In the course of the company's business planning (both in its early stages and as updates are made with time), the company plans in advance the most efficient way for reaching its goals. The company should take part in joint ventures or other strategic alliances if it finds that this would be a more efficient way of reaching its goals than a route in which the company independently invests the financial and human resources required to reach these goals. Alternatively, it should do so if it concludes that it will be unable to reach such goals independently. As an alternative to acting independently or jointly with another entity, the company can buy services from outsiders (otherwise known as outsourcing). This section will briefly examine when the company should opt for a strategic alliance and the best way of implementing it. This discussion is separate from that on mergers and acquisitions, an alternative to strategic alliances (see Part V), and from the discussion in Chapter 11 of the functions of strategic investors in the company.
The Advantages of Strategic Alliances
Many startups find that cooperating with stronger and better known companies can help them break into the market faster and secure less costly financing than would otherwise have been available to them.
In the past, joint ventures focused on the representation of companies in various countries or geographic areas. In the past decades, the phenomenon of joint ventures for predefined activities has become more prevalent. An alliance can impart to the company a relative advantage in size or an ability to learn the field faster, or provide a complement to areas in which it is lacking (for instance, an alliance between a startup with an advantage in development and production with a company with proven marketing skills). When the joint venture is performed in a formal manner, by establishing a separate legal entity for it (also known as the joint venture), it is similar in nature to a partial acquisition in consideration for shares (see Part V for merger and acquisition transactions). This is because the transaction creates an entity that combines the relative advantages of both parties and ties their futures together, at least with respect to the field in question.
The Disadvantages of Strategic Alliances
Alliances are costly, not only due to cash leaving the company's hands, but rather due to returns from which it could be denied. First, joint ventures involve the investment of managerial time resources in establishing the venture, managing it, and resolving possible conflicts of interest between the partners over the functioning of the venture. Even when a proper set of contracts, incentive schemes, and various transfer prices from the partners to the joint venture resolve most conflicts, almost no joint venture manages to entirely avoid conflicts between its respective parties.
Moreover, alliances can create indirect costs by blocking the possibility of cooperating with competing companies, thus possibly even denying the company various financing options. For instance, an alliance with Ericsson in the area of cellular communications could reduce the likelihood of contracts with Nokia, thereby putting the company at risk that if Ericsson is weakened, so will be all the companies that depend upon it.
Joint ventures also expose the company to its partners, and the unique technologies that it has are sometimes revealed to its partner company, which could later become a competitor or could utilize the fruits of the venture or the know-how better than the startup itself. In addition, strategic partners may often lead the company in directions that serve the partner company better than they do the company itself.
Although a material part of the costs of joint ventures may be forecasted during the negotiations for its establishment, in many cases the balance of power between the parties changes during the course of the venture's life, and the parties to it may have a change of mind. For instance, many joint ventures that were signed before the stock market crises of 2001–2002 between public companies and startups never materialized due to the drop in the stock prices of some such public companies. The fact that some of the private companies had meanwhile raised capital and actually had become stronger than the public companies, utterly changed the balance of power. Likewise, the non-raising of capital by the startup could motivate the public company to try to renegotiate the terms of the venture, while taking advantage of the startup's weakness. A change in the competitive environment in the field could also affect the alternative cost of the venture. For instance, if Nokia were to increase its share in the cellular market, then the alternative cost of the venture with Ericsson (namely, the economic value of the reduced opportunity to do business with Nokia) would be augmented over time.
Types of Strategic Alliances
In strategic alliances, at least two entities agree to combine economic resources—either financial resources, know-how, or material assets—in a contractual framework in order to achieve pre-defined strategic objectives. A simple arrangement, to be discussed in Chapter 5, is the granting of a license to use technology, within which one company provides the know-how and another company pays royalties in consideration for the know-how, either in the form of equity or cash, in amounts that may be conditioned upon performance or be fixed in advance.
Other setups combine in a single agreement an investment by one of the companies in the other, with the other company allotting equity in consideration for the investment, and providing know-how or products to be incorporated into the investing company's manufacture, production, marketing, or development systems. In such setups, it is often hard to evaluate each of the various individual components of the transaction. Such distinction is essential for the companies' financial statements, since many transactions combine capital components (i.e., an investment) with components in the income statements. For example, a transaction in which Amazon (the world's largest online bookstore) invested in drugstore.com (an online pharmacy) in consideration for equity, and drugstore.com bought advertising space on Amazon, raised the issue of the pricing of the different components of the transaction. In such a case, Amazon could ultimately gain more cash than it invested, while recording advertising revenues higher than its investment and recording an investment of the cash it put into the transaction. The Securities and Exchange Commission (SEC) often examines the manner of recording of such transactions and in many cases requires clarifications, and even changes to the way such transactions were originally recorded.
Arrangements that include components of an investment in equity have been highly popular in recent years and usually produce long-term alliances. In many cases, a new entity is created in which the companies invest money and know-how. For example, FDC, one of the largest companies in the world for money transfer services, established a new company for Internet-based payment systems, together with the investment bank Goldman Sachs and the venture capital fund General Atlantic, for a total investment in excess of one billion dollars. A main component of FDC's investment was its share in ventures in which it had invested beforehand. Such transactions are common when one of the parties to the transaction is not interested in diluting a stable and profitable company, but is interested in allotting shares in a new activity in which it invested, which could arouse investors' enthusiasm.
Cooperation arrangements bestow on both parties many of the advantages involved in mergers and acquisitions, without the need to bear the high premium entailed by a change of ownership. Such arrangements further provide the option to choose the essential components in the other party to the transaction, without the need to acquire and then sell the segments that are of no interest to the acquiring company. Furthermore, strategic alliances typically do not require the approval of the company's shareholders, and are generally welcomed by capital markets more than are acquisitions.
Various research has demonstrated that joint ventures are more successful when the management cultures of the partners are compatible and when the senior management of the companies is committed to them. In many cases, one of the parties invests more money if the other party agrees to run the business or, alternatively, transfers know-how to the business. In other cases, the partners take equal shares in the ownership but not in the management, and both parties have the right to veto various material resolutions, such as large transactions, the acquisition or sale of assets, and so forth.
An ownership interest in a joint venture that is formed as an entity is considered an investment in another company for reporting purposes. In other words, the principles of the cost method, of the equity method, and of consolidation are applicable here, too (see the earlier section in this chapter on reporting holdings in other companies and consolidation of statements). However, in many joint ventures the company uses the equity method to reflect its investment even when its holdings are smaller than 20%, since in most cases each of the companies has a material impact on the management of the venture.
There could be material timing differences between the financial reporting and the reporting for tax purposes, since the tax reporting will often be made according to the cost method, whereas the financial reporting will be made according to the equity method.
Like mergers and acquisitions, transactions that could affect competition in the market are subject to the scrutiny of the antitrust authorities. The examinations that are made are similar to those made in cases of mergers or acquisitions (see Part V). In recent years, many alliances have been exposed to scrutiny by the authorities. For instance, a joint venture of some large automobile manufacturers underwent intense scrutiny to examine its effect on the suppliers of these companies. As a result of the creation of many e-commerce platforms in recent years, various rules of reporting to the authorities were fixed for the establishment of such platforms.