Growing the Firm Through New Business Development
Chapter 8 in
Strategic Thinking
A Strategic Management Textbook
Gordon Walker
Professor
Cox School of Business
Southern Methodist University
Dallas TX 75275
Introduction
Almost all firms begin as a single business, competing in one industry with a
single product line. For example, Intel - which has developed the world's standard
microprocessor for personal computers - originally produced memory chips. Dupont one of the largest chemical and plastics companies in the world - began as a gunpowder
company. IBM - the world's largest computer firm - started as an adding machine
company. GE - perhaps the most successful diversified company - began as a producer of
light bulbs. Electronic Data Systems (EDS) - the second largest provider of software and
computer outsourcing services in the world - originally sold computers through leasing
arrangements. The list of large dominant firms currently in a major business that is a
significant variant or radical departure from the firm's initial enterprise is very long.
Moreover, every larger or older firm continuously experiences pressures to diversify its
line or lines of business in order to maintain growth in assets and revenues. Further, many
large firms currently in primarily one business - e.g., General Motors, Coca-Cola, Kodak
- have historically been diversified more broadly, frequently with poor results.
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What are the factors that lead a firm to diversify? How should managers think
about diversification? We will address these questions in this chapter by examining the
issues facing firms when they introduce new businesses by developing them internally.
Mergers and acquisitions are dealt with in a later chapter.
We begin here with a discussion of the contributions the firm can make to a new
venture. A central theme is the contribution of the firm’s resources and capabilities to the
new venture for achieving and defending competitive advantage. When and how much to
leverage existing firm resources in developing the new business are central questions in
new venture creation and growth. The value of these contributions also depends in part
on whether there are effective substitutes for them in the input markets of the venture and
its competitors.
Next, we will examine how firms manage the development of new ventures in
relationship to existing businesses. New ventures must be identified as economically
promising in the context of the firm's organization-wide resources and capabilities. The
economic promise of a new business is not only highly dependent on this context but on
the implications of the business for the firm's multi-business strategy. Also, the
relationship of a new venture to existing businesses must be managed systematically to
take account of the new market or technological characteristics that make the venture
innovative.
At some point in its history, commonly when the potential of its initial business
wanes, a firm begins to search for other markets to apply the skills and resources it has
developed. There are two general types of new market opportunity. The first is a new
geographical region, e.g., a country, where the firm can clone its original business with
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some modifications for local preferences. The second opportunity is a new product
market involving a new technology, a new set of customers or both of these.
Success in the new market may not require the firm to set up a new business unit.
In this case we will say that the developing and delivering the new product effectively
entails only an extension of the firm’s product line within the existing structure of the
organization. Since a product line extension means that no new business is set up within
the firm, this is not an instance of diversification. Diversification occurs only when the
firm develops a new independent unit with its own strategy and activities.
Multi-business firms face a distinct set of strategic challenges. Each business unit
in the corporation competes in its own product market, both helped and hindered by the
resources available within the parent corporation and the systems the corporation puts in
place to manage the businesses as a group. The more enabling these resources and
systems, the more the corporation adds value to the businesses. The more constraining,
the less value is added.
The tension between what the corporation adds to the business units and what the
business units provide the corporation increases with the rise in the number of units and
the organization's age. To reduce the failure rate of new businesses, firms select their new
ventures carefully and often develop them separately from established businesses. The
selection and development of ventures are thus important for the overall growth of the
firm.
Diversification may occur for a variety of motives. It can be a response to an
emerging opportunity related to the firm's core business. The firm may start the venture
to achieve a strategic advantage that can only be attained at a particular stage of market
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development. Alternatively, the firm may see diversification as an expansion path to
avoid competitive difficulties in the firm's core businesses. Establishing new businesses
rarely solves the firm’s economic problems, however. More often, diversification
compounds them.
The firm and the new business
As a firm begins to think about diversification, it can ask two questions:

What is the new business going to do for the firm?

What is the firm going to do for the new business?
The first question typically pertains to the ways in which the new venture contributes to
the firm’s financial performance and the other businesses in the firm. There are three
contributions the venture can make to the corporation:

corporate reduction of systematic risk

corporate growth in revenues or earnings

favorable repositioning of current businesses.
The second question has the reverse perspective - what does the firm add to the
new venture? Given that the new business must compete effectively to produce targeted
financial returns, what resources and capabilities can the firm give it to strengthen its
market position and increase its performance? This question focuses on leveraging the
assets of the firm as it grows through new business development.
Contributions of the venture to the corporation
Risk Reduction. A prevalent reason for diversifying is to reduce the systematic
risk of the firm's stock price, thereby increasing its value. This financial motivation
cannot be a sufficient reason to diversify simply because, by diversifying the
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corporation's risk through adding new businesses, managers are taking on a function
assigned to shareholders, who would typically diversify the risk in their portfolios
through owning shares in companies whose returns are uncorrelated. Since the costs of
diversification would normally be much larger than the costs of adjusting a stock
portfolio, it seems clear that adding new businesses to lower the corporation's financial
risk is a poor use of resources. 1
A second type of risk reduction is the smoothing of corporate cash flows over
predictable and recurring shifts in demand such as seasonal buying patterns, the business
cycle, or some other regular pattern in revenues. Constructing a portfolio of countercyclical businesses has a similar motivation to reducing systematic financial risk in the
corporation’s share price. The difference is in what is being smoothed – stock price or
cash flows. The similarity between the two motivations is that the corporation adds
nothing to the new business to help it compete in its product market. So while reducing
the risk associated with a firm's share price in the capital market is a worthwhile goal, it
should be subordinated to improving returns in each business unit, which can only occur
when the corporation builds strong ventures or develops ventures that strengthen current
businesses.
Corporate growth in revenues and earnings. It almost goes without saying that
new businesses are developed with the intention to grow the firm’s revenues and
earnings, especially as the growth of core units has slowed. However, a singular focus on
corporate financial goals, based on experience with the firm’s traditional core, may divert
attention away from valuing the new unit based on the firm’s contribution to it. A firm
that repeatedly starts or buys new businesses to improve its financial performance may be
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successful if it has superior information consistently relative to competitors with similar
growth strategies.2 However, greater and perhaps more sustainable value is achieved by
effectively leveraging the firm’s resources and capabilities into the new business.3
Although increasing corporate performance, as a goal, determines which new businesses
are most attractive, goals do not achieve themselves.
Contribution to core businesses – repositioning. New business development can
also be motivated by the need to reposition one or more of the firm’s existing businesses.
In this case, the new business adds resources or capabilities that improve the economic
performance of core business units. For example, global media companies, such as Fox,
Disney, AOL Time Warner, Vivendi and Viacom, commonly expand through the
development or acquisition of content or distribution businesses. Ted Turner’s purchase
of the MGM film library provided his existing television stations with a rich source of
programming that expanded their market. Fox’s development of Fox Kids allowed Rupert
Murdoch to offer a more complete bundle of programming to distributors in international
markets, thus increasing the value of his existing businesses.
There are three major risks in repositioning attempts. First, the benefit from the
new business is lower than expected, as AOL has discovered regarding its acquisition of
Time Warner. Second, the isolating mechanisms protecting the contribution of the new
business to the diversified firm are weak, so competitors can copy or design around it.
Third, the diversifying firm does not have the resources or capabilities to sustain the
market position of the new business so that over time the market position declines and
with it the benefit it makes to the firm. The downside to these risks becomes less
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significant the more the company contributes over time to improving the new business
and the unit succeeds in its market. 4
Contributions of the corporation to the venture. There are in general five types
of contribution the corporation can make to the new business:




Financial capital
Resources, such as distribution channels or brand equity
Capabilities in activities such as marketing or operations
Entrepreneurial management skills in growing or revitalizing
businesses
 General management skills in managing larger businesses
Each of these inputs may also be available from market sources. So each corporate
contribution substitutes for a contribution that could be made by a market supplier. The
value of the corporation to the new business should be determined with reference to these
market alternatives, since in some instances the new business may benefit more from
using the resources of other firms than those of the corporation itself.
Financial Capital as a Corporate Input When corporations allocate funds to
business units, they substitute for external sources of capital. A corporation is therefore
frequently viewed as having an "internal" capital market. An important question is how
well an internal capital market functions compared to the "external" capital market in
which resources are allocated through trading and lending activities. As a source of funds
for new businesses, there seems to be little doubt that on average corporations cannot be
more efficient than the external markets they replace. Therefore, just having the capital to
invest in a new venture is not a sufficient reason for a firm to diversify.
However, there may be exceptional cases where the firm is the more effective
source of funds for a new business. The most obvious exception is when there are biases
in the external capital market against certain types of business, for example, those that are
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smaller. Smaller businesses are typically suffer a liquidity penalty in their valuation. To
correct for this bias in their evaluations of smaller firms, analysts estimate an adjustment
factor. Since there is no reason the estimates of an analyst within a corporation could not
be more accurate than those of an analyst in an investment bank, a corporation might
make better resource allocation decisions than investors in the capital markets.
The critical question, however, is why some corporate analysts might be better
estimators of small firm, or new venture, value. There is no clear answer to this question
but a number of suggestive ideas. One reason some corporations may have an advantage
is that they have better information to improve their valuation estimates. To provide a
consistent advantage over time, this information must be available continuously for
investment decisions and its source must remain within the corporation. A second reason
an advantage may exist is the skill of the analyst or the analysis team. If this skill is
highly generalizable across new businesses, then the analysts resemble venture
capitalists, expanding the scope of the firm’s diversification.
Leveraging Firm Resources. Perhaps the most straightforward rationale for
diversification is the exploitation of excess capacity - either current or prospective - in
some part of the firm’s resource base. Examples of this type of diversification are legion.
They range from Dupont’s move from gunpowder into paints in the early 1920’s – based
on excess operating capacity after the end of WWI – to Amazon.com’s introduction in
1999 of toy and electronics merchandising – based on its central electronic commerce
channel for books and music.5 In Dupont’s case, the resource is empty plant floor space;
in Amazon’s case, the resources are primarily its large customer base and the brand
equity of its webpage as a marketing channel.
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We can use these two examples to understand better how leveraging resources can
enable new business development. First, the resources at Dupont and Amazon are located
in some part of the firm’s value chain. Dupont is primarily leveraging its operations, and
Amazon primarily its marketing. So operations will be linked between the old and new
businesses at Dupont and the marketing channel will be linked between the old and new
businesses at Amazon. The other activities in the value chains of each firm may link the
old and new businesses, or may not, depending on the contribution they can provide to
the venture’s success. In fact, the greater the number of resources in the original
business’s activities that are used in the new venture, the closer the two units are in the
way they compete in their product markets.
Since every diversification event involves entry into a new industry, the key
question the firm must ask is the following: what strategic value do the leveraged
resources from the old business or businesses give the new venture? Answering this
question has three parts. The first involves identifying how the leveraged resource
positions the venture in its product market in terms of value and cost drivers. The second
concerns their resources’ contribution to the venture’s execution of its strategy within its
market position. The third part involves a comparison of the resource to alternative
resources that might be available to the venture in the market.
As we discussed in Chapter 1, every business is positioned in its product market
on a set of value and cost drivers, which determine the firm’s economic contribution. The
resources the firm leverages in its new venture tie it to a particular market position based
on these drivers and determine how the venture will compete. There may be other firms
in this industry position competing with similar resources and capabilities. The
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diversifying firm should therefore ask whether its current businesses have resources that
allow the new unit to position itself more effectively than rivals. If the firm's resources do
not position the new business competitively, then any positive returns to the venture will
driven more by industry factors, such as high growth and weak buyers and suppliers, than
by competitive advantage.
One must also ask whether the parent company’s resources are more valuable for
the venture than the resources it could purchase elsewhere or develop independently of
the parent. This perspective focuses on what resources and capabilities would be
necessary to achieve targeted financial returns in an industry and includes the parent
corporation as only one of several possible sources of these inputs. For example,
Amazon’s on-line electronics store leverages its parent’s web-site. To the extent internet
electronics businesses have higher margins and faster growth than non-internet
competitors, Amazon’s new unit benefits from being part of its parent’s web site. The
next question is whether Amazon’s brand and customer base, which are specific to its
web site and its position as a leader in electronic commerce, contribute more to the
economic performance of the venture than those of other internet companies. If selling
electronics over the internet is more profitable than through other channels - but
Amazon’s brand equity does not extend to this business, either in inducing new or current
customers to buy – then the venture benefits from being part of Amazon only in that the
parent is internet-based. The fact that it is Amazon.com may not be significant for the
venture's performance. The important point here is that when Amazon as a brand or
source of customers is not a factor in the on-line electronics store's performance, the store
may as well source its web portal from any internet supplier.
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It should be obvious that Dupont's excess capacity in operations was probably not
a critical resource for the company's new paint business. This business, standing on its
own outside Dupont's institutional boundary, would have been able to find a facility
somewhere that matched the empty gunpowder factory, probably at a comparable price.
So Dupont, through using its excess capacity, added little or nothing strategically to the
new business. To make the new business succeed over time, other resources or
capabilities from the core business were necessary. Unfortunately, these contributions
were hard to come by, and the paint business under-performed the market consistently
until new senior management, who reorganized the whole corporation, was installed in
1923.
In this sense, all inputs of the firm to its businesses can be seen as alternatives to
inputs offered in the market. Since resources are perhaps the most visible of the firm's
contributions, they are likely to have alternative sources in external markets. Both the
business and the firm must then ask themselves whether the firm's resource is superior as
a source of economic gain compared to the competing market alternatives. If so, then
leveraging the resource makes economic sense. If not, then other rationales for
diversification must be sought.
An important way to think about leveraging resources among business units and
benchmarking these resources against market alternatives is economies of scope. We have
discussed economies of scope earlier as a cost driver for products within a single business
unit. As a cost driver within a business, scope economies lower the costs of multiple
products through combining their production in one or more activities.
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Achieving economies of scope is necessary and sufficient for the effective
leveraging of resources and capabilities across business units almost by definition.
Without economies of scope in combining the activities of the venture with those of the
current business or businesses, there is no benefit from sharing and therefore no
leveraging of resources or capabilities, as they are anchored in the activities of the firm.
Further, if potential economies of scope exist, then there can be an economic benefit from
combining the activities and an opportunity to leverage the resources and capabilities
inherent in them.
Linking economies of scope to market benchmarking is important since it extends
the framework developed for understanding the firm's boundaries. The key point here is
that these economies are achieved through the firm's superior ability to coordinate the
planning and execution of the combined activities compared to their separate execution in
the market. Such a coordination advantage is possible only if the activities are in some
way specialized to each other, since if they were standard activities, the coordination
would be easily carried out through straightforward market contracting.
The specialization of the activities also makes sense in that specialization is a
necessary (but not sufficient) condition for providing the venture an economic advantage
in its product market. A standard activity would not provide an above average economic
benefit since it would be available to all competitors. So economies of scope are achieved
when the firm is effective at coordinating the joint execution of specialized activities
shared by both the firm's incumbent business and its new venture, and this effective
performance is superior to that possible in the market. We will look later at the range of
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coordination mechanisms that firms use to link their current and new businesses in order
to achieve sustainable above average returns in the new venture's market.
How much is this superior coordination ability worth? One example of the value
of a shared resource is the price premium attached to a corporation's brand. The key
coordination task here is ensuring that the value of the brand is maintained in each
business that uses it. An extreme instance of this is the GE water heater, a product that is
produced by a private label manufacturer and sold through Home Depot, which initiated
the product concept. GE merely brands the product and receives a percentage of the sale
price, which is higher than water heaters with lesser brands. This percentage is a return to
GE on its ability to coordinate procedures across its very broad range of products that
guarantee of a level of quality that is higher than generic products, in this case home
appliances, which are in general virtually undifferentiated in quality. These procedures
constitute a capability that allows the brand to be leveraged as a resource. Achieving
economies of scope thus entails developing and maintaining capabilities, to which we
will now turn.
Leveraging Capabilities in Activities. The third type of contribution a firm may
make to a new business is a capability developed in one or more activities in the value
chain. For example, the firm may have become expert at flexible manufacturing systems
in its original business; or at building and managing partnerships with suppliers of key
components; or at marketing a line of technologically complex products to business
customers; or in the case of the GE water heater, managing relationships with private
label suppliers and mass market distributors to ensure that the premium of the GE brand
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is maintained. Moreover, more than one type of distinctive competence in the core
business may add significant value to the new venture.
The potential for leveraging capabilities within the firm and the availability of
market alternatives for them raises a number of key questions. First, how does the
capability add value to the new business? Like a resource, the expertise must add or
enhance a value or cost driver and thereby improve the market position of the venture
against competitors. Second, how can the capability be transferred to the new business?
Assuming that the new venture is separated institutionally from the firm’s original
business, so that the venture comprises a distinct value chain, the firm must find a way of
implementing the capability within the new unit. This transfer is facilitated enormously if
the capability’s procedures can be codified and elements of the procedures can be taught
and communicated effectively. Personnel from the original business may also be
transferred to the venture show how the capability should be executed. But there are a
number of challenges to such a transfer. If the capability is based on teamwork developed
over time, codification captures only a small portion of the overall set of procedures.
The paradox of transferring a key capability from the original to the new business
is that the more useful they are to the venture, the less transferable they are likely to be.
First, more team-based capabilities that are difficult to codify are more difficult to
imitate. But the act of trying to generalize the capability through applying it across two
businesses raises the risk of exposing its observable qualities. The chance of at least
partial imitation by rivals is thereby increased, which reduces the capability’s
contribution to the venture’s performance over time.
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This problem is especially acute for firms making their first diversification
attempt. Although a single business firm has experience applying its capabilities in its
original market, it obviously has no experience in generalizing these practices and so
cannot know what can be transferred effectively. Moreover, in attempting to create
templates that capture the firm’s capabilities, the firm exposes what has been hidden up
in the informal expertise of its personnel. Diversification therefore requires efforts to
standardize processes in the single business firm, if its capabilities are to be leveraged
successfully.
Leveraging Entrepreneurial Capabilities. Resources and capabilities are not the
only assets a firm may transfer effectively from an old to a new business. In many
instances, the entrepreneur has previous experience managing rapid growth in other
startups. To the extent this experience provides valuable insights at critical points in the
firm’s expansion, the management team can be said to have developed a capability for
growing a business across major increments in size.
Growing a new business requires building capacity in all activities with an eye
both to trends in demand and to competitors’ responses. In addition, as we have seen in
earlier chapters, boundary decisions must be made regarding the activities that are
required for executing the venture’s strategy. Some activities will be performed by the
business itself, some by other units within the parent corporation, and some by outside
suppliers, perhaps through partnering arrangements. Both capacity expansion and
boundary choices are ongoing challenges as the business expands, and knowing when
and how to make appropriate investments can improve the performance of the venture.
For example, during the 1999 Christmas season, Amazon.com had fewer stock-outs in its
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on-line toy store than its major rivals, toysrus.com and etoys.com. Due to its greater
experience in large scale holiday purchasing through the internet, Amazon was able to
predict demand and manage logistics requirements more effectively in its startup toy
business.
The management experience within the parent corporation that is relevant to the
growth of the new business and can be shared is thus a potentially valuable capability for
the venture's expansion. Clearly, the less similar the growth demands of the venture to the
history of growth in the parent's existing businesses, the less applicable will
management's experience be. Growing ventures in industries whose technologies or
customers have radically different characteristics from the original business of the parent
corporation is therefore riskier.
Core Competence. One of the most important concepts, introduced over the past
twenty years, for understanding successful product diversification is core competence.
The idea of a competence is broadly used by managers to denote a type of capability. .
However, the original meaning of the term core competence is something much more
complex and far-reaching. 6
The central idea of core competence is that multi-business firms may have one or
more technological resources or capabilities that can serve as a foundation for new
business development. These capabilities are shared and developed jointly by more than
one business unit so that economies of scope are achieved in the growth of the
technological platform. However, the scale and complexity of core competence are much
greater than simple diversification one new business at a time.
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Core competence is not just the existence of a technology platform shared across
business units. It is also the ability to develop new businesses based on the innovations
produced. The development by the firm of new business units that build on and feed back
into the technology platform expands the firm's reach and growth path beyond the
product line extensions we discussed earlier in the book. The new technological
applications on which new businesses are based, when shared with other business units
within the corporation, may stimulate further innovation which in turn leads to more
entrepreneurial activity. The entrepreneurial dimension of the concept of core
competence is therefore critical for understanding its power as a mechanism for corporate
growth.
Core competence is thus a combination of two types of corporate contribution to
the business: technological capability and entrepreneurial skill. Both of these are
necessary, and neither is sufficient, for a firm to grow through technology-based product
diversification. The sustainability of such an expansion path is a key issue for diversified
firms, especially as technology platforms change in value over time and opportunities
increase for entrepreneurial activity outside the corporate boundary.
One of the best examples of a firm that has developed and exploited a core
competence is 3M. 3M is known for the enormous number of innovations it has
developed in advanced materials, especially adhesives. Post-it notes was perhaps the
most notable example of the corporation's diversification into unusual and unusually
successful applications of adhesives technology, as well as one of the initial stimuli for
the initiation of a large, aggressive program to support new business development. The
combination of 3M's highly generative technology base in materials and its promotion of
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the formation of new businesses tied to this base has constituted a major source of growth
for the firm over the past twenty years.
One advantage of defining core competence as the joining of both technological
and entrepreneurial capabilities in the firm is that it forces the firm to define more
precisely the benefit it receives from a specific technology platform. Frequently, when a
firm defines its competences compared to competitors, it overestimates the importance of
existing technology for future economic performance. Specifying the applications that
might be built into new businesses, which in turn would be aggressively grown through
the corporation’s entrepreneurial management skills, reduces the upward bias in these
technology estimates.
Leveraging Strategic Capabilities. The second type of management capability a
new venture may receive from the original business is expertise in designing and
implementing a particular strategy. Some corporations specialize in building businesses
by emphasizing either cost advantage or value advantage. The benefits of corporate
specialization in one of these types of market position are: first, managers across
businesses can share a common set of practices for building and sustaining market
positions; and second, corporate executives have a more homogeneous and therefore
more comparable set of investment proposals from the businesses to evaluate. Investing
in one type of business strategy over time increases the corporation's expertise in
identifying higher return opportunities compared to corporations that have less
experience because their pool of proposals is more diverse.
One firm that manages a portfolio of businesses each of which emphasize cost
advantage is Emerson Electric. This firm manufactures consumer and industrial durable
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goods, primarily with engine or motor components, and competes at the low end of the
market with consistent success. By leveraging cost management expertise in new
ventures and applying stringent performance criteria to each business, the corporation
grows revenues and earnings.
In comparison, Johnson & Johnson specializes as a corporation in increasing the
value advantage of its products and services to health care professionals. This emphasis
has been challenged as price competition in health care has increased in the last two
decades. In response, Johnson & Johnson has striven to lower the costs of its businesses
while maintaining to a large extent the decentralized structure that promotes new business
generation and growth in current businesses.
Market Characteristics
In the discussion of leveraging resources and capabilities to diversify effectively,
we have not described the characteristics of the markets the firm may diversify into.
Attractive markets are clearly growing and potentially large. But perhaps more important,
they should be markets in which the firm can compete effectively. Every diversification
decision is also an entry decision. The new market should be enough like the one the firm
started in to allow a productive transfer or sharing of existing resources or capabilities,
and the transfer is productive when the existing assets contribute in an important way to
establishing and maintaining a competitive advantage for the firm in the new market. 7
What is an attractive market opportunity? There are three basic conditions. First,
the ultimate size of the new market must be large enough to support the achievement of
the firm's goals regarding the contribution of the new business to corporate profitability.
This obvious condition is often overlooked by firms diversifying into fast growing
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markets whose ultimate size is moderate. Second, the future growth rate of the market
should be sufficient to enable the firm's new business to learn and innovate within its
newly established market position. It is very difficult to make the adjustments necessary
for long term viability when incumbent competitors are battling for a dwindling number
of customers. Last, the new business should be favorably positioned in the future industry
structure. The new venture’s growth strategy is likely to be more effective if it is directed
at dominating a future market position that is both stable and large enough to support
continued investment. Developing this position by transforming the industry's current
structure is a major task of diversifying firms. 8
The Process of New Business Development
How do firms plan and launch new ventures? This process occurs in the context
of an established, viable, perhaps dominant, business or set of businesses that defines the
firm's strategy. New products, around which new businesses are built, can frequently
cause existing product lines and perhaps the strategies that made them successful to lose
their attractiveness. In many cases, firms resist introducing new products because of
commitments to incumbent investments that characterize the firm's strategy. In fact, in
most firms, the current strategy is the lens through which all proposals for new
investments are assessed.
Consequently, we need to consider where new concepts originate; how they are
developed through the organization; how they interact with the current strategy of the
firm; and then how they are implemented as that strategy is changed to include them.
Most new business ideas originate outside the normal operations of the corporation.
These ideas are typically initiated by managers whose view of markets and technologies
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is not dominated by the ongoing thrust of competing through the firm’s core business.
Without a sufficiently large cadre of these innovators, a firm facing changing markets
may be unable to survive.
The behavior of these managers is strategic in the sense that their ideas determine
in large part the projects in which the firm will invest in order to compete in its changing
markets. However, as strategic behavior, the development of innovative ideas around
which new businesses are built is separate from the firm’s traditional competition in its
core market and to a degree independent of the firm’s current strategy. Obviously, if the
new ideas were not relatively independent of the current strategy, they would not serve
the function of aligning the firm’s investments with new market requirements.
The more markets are changing, the more new ideas need to be produced to create
a viable expansion path for the firm. But not all the innovations proposed are useful,
practical, or implementable within the constraints of the firm’s technological, institutional
and political systems. Each idea must therefore be judged appropriate for the firm.
Making these judgments is a key role played by upper management, who are sufficiently
attached to and knowledgeable about the firm’s current strategy to understand its merits
but are also detached enough from it to appreciate its limitations. These executives act as
a filter through which new ideas are passed.
Those new ideas that are sanctioned by the members of the firm’s upper
management become business proposals to be compared for resource allocation. The
choices made among these proposals determine which markets the firm will compete in
and how it will compete over the next planning cycle. If no new proposals are generated,
the firm’s strategy remains unchanged. However, if new projects are proposed and
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accepted, there is a strong likelihood that the strategy will shift and a new concept of the
firm will emerge. Thus the decisions of upper management regarding innovative projects
are essential for the development of the firm’s strategy as a matching of resources and
capabilities to economic opportunity in the market.
These decisions are not made independently of the demands the firm’s current
strategy puts on management. As senior management evaluates the new concepts being
proposed, these executives are also working to implement the current strategy effectively.
Clearly, no firm can expand or change successfully without maintaining a solid, stable
core of earnings that produce resources needed to build the new market position and
organization. So, along side the non-routinized process of producing and filtering
innovative concepts exists the routinized process of effectively implementing the current
strategy. How the firm relates the non-routine and the routine is critical to its ability to
adapt to change in markets that produce new business opportunities.
The joint processes of new concept generation and current strategy
implementation, joined by the dual role of senior management in the firm, are shown in
Figure 1. Here the underlying concept of the firm’s strategy is the central reference point
for both processes. New concepts for business diversification arise throughout the
organization and are fed to senior management for review. Those concepts that are
accepted change the current strategy as new businesses are added to the firm. This
process is guided by the structure of relationships among the firm’s managers, which is
designed to implement the firm’s strategy effectively. As the firm’s strategy changes
though diversification, so does this network of relationships. The new structure
22
introduces a new filter for assessing new ventures, and the process of diversification
through internal development continues.
How should new ventures be managed?
Once a venture has been chosen for investment, the firm must decide how to
manage its growth while continuing to expand the more mature businesses in its
portfolio. There are two major challenges for the firm in managing this process. The first
involves the separation of the new venture from the existing businesses so that it can
establish an expansion path unencumbered by the operating procedures, management
practices and incentives that have been developed to govern the more mature units. This
challenge is called the task of differentiation (not to be confused with product
differentiation in the eyes of customers). The second challenge concerns the need to link
the venture with the firm's resources and capabilities so that they can be used to create
value for the firm in the new market. Establishing and managing these links is called
integration (not to be confused with the vertical integration of production processes). 9
The degree to which the new business needs to be differentiated from the
corporation's core businesses depends on two major questions: 1) How well can the
venture realize its growth and economic performance goals when it is nested in the
managerial and operating systems of the corporation? 2) How should the venture leverage
the activities it shares with other corporate units in order to meet its goals? The answer to
the first question is often no, while the second question raises a number of issues bearing
on how the relationship between the venture and the corporation should be coordinated.
These issues are different from those pertaining to relationships between the more mature
23
businesses in the corporation, since the venture frequently must be subsidized early in its
history.
A classic example of a mismatch between new and incumbent businesses involves
ventures based on disruptive technologies. These ventures are typically underfunded and
poorly managed by the firm's core management systems. The reason is that they are
focused on markets that are outside or peripheral the corporation's customer base and
forecast performance levels that are too low to be considered significant in the business
unit portfolio. Nonetheless, the strategic significance of these ventures can be very high.
Therefore, the first key issue for the governance of new ventures within the larger
firm is how to emulate the advantages of starting up a company in the market and avoid
the disadvantages. The more alien the new market, both in terms of its requirements and
its initial size, from the modal customer base of the firm, the less support the venture is
likely to get from the firm. But if the venture is recognized as strategically important, the
tendency to under-fund and under-manage needs to be corrected.
There are four areas in which new venture governance may occur. The first is the
establishing multiple perspectives on business unit valuation within the firm. New
ventures often require a set of performance metrics that are appropriate to their markets
and strategic goals. Using these metrics releases the venture from the application of
measures used for the firm's more mature business units.
The second area of governance is the use of separate resource allocation
mechanisms. Because of the ongoing market uncertainty the venture faces, it is often
difficult to estimate the economic performance of its projects with adequate precision.
But funding many of these projects may be critical for the new unit's success. A different
24
set of rules for allocating resources to new ventures therefore needs to be developed.
These rules should impose resource constraints on a venture in the context of its strategic
implications for the corporation, which should include estimates of both the upside
potential of success and downside risks associated with failure.
The third governance area involves managerial incentives. In industries facing
substantial innovation, most firms need a stable, significant cadre of entrepreneurially
oriented managers to initiate and grow new businesses. Without such a group, the firm is
typically reduced to managing mature, low-margin businesses with little prospect of
growth. However, many managers are loath to startup new ventures since the early
payoffs are virtually non-existent and later payoffs, however large, are fraught with risk.
Consequently, clear models indicating the personal benefits of entrepreneurial success
within the firm need to be developed in conjunction with the rewards associated with
meeting the goals of businesses later in their life cycles.
The fourth area concerning the governance of a startup business involves its
position in the firm's formal and informal structures of interunit coordination and
control. First, diversification occurs only when a new business unit is created, organized
as a profit center and responsible for developing and executing its own strategy. This
means that both transfers between units and the joint use of resources are governed
almost as if they were part of a market as opposed to within an organization. Quasimarket mechanisms within a firm are therefore necessary for interunit coordination.
At the market end of the governance spectrum are pricing systems through which
the venture buys goods and services from other businesses. The prices are often set
through comparisons with similar transactions external to the firm. This system produces
25
the greatest differentiation but reduces the resource benefits of incubating the venture
within the established firm. At the organization end of the spectrum, the venture is
located within an existing business unit and is subject to its administrative procedures and
constraints. Assuming the business unit provides the venture with significant resources,
the venture benefits from joint production arrangements. However, entrepreneurial
incentives are dulled.
Most firms, therefore, adopt coordination and control mechanisms somewhere in
the middle of the spectrum - combining market and organization arrangements that
increase the venture's chances of success. Firms that have established a history of
successful new venture development can rely on this history to set expectations for
governing new businesses. Successful ventures and entrepreneurs serve as models to
emulate. These models are effective as guides for managing new venture development
and coordination with core of the firm. New market conditions require new mechanisms,
however, moving either towards greater independence from the firm, or towards greater
integration.
Carve-outs. One way to maintain entrepreneurial incentives within the firm, as
well as provide a means to the firm for valuing the venture, is to offer equity in the unit to
buyers in external capital markets. Venture managers vested in the unit's stock may gain
substantially when it goes public, in amounts similar to those possible had the venture
been independent. The firm also benefits from holding stock in the venture. Corporate
managers therefore are more receptive to new ventures ideas that have a high potential
for economic performance as valued by public equity markets. Thermoelectron pursued
this strategy successfully in the early phases of its diversification history. 10
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In some cases, the value of a venture may be driven more by valuations associated
with its industry than the benefits received from the parent firm. Here a firm may
establish a separate stock for the business in order to realize gains that would not have
been possible had the unit remained within the parent. The slow separation of SABRE
from American Airlines is an example.
Diversification in Different Nations
We have emphasized the importance of the contributions existing businesses or
corporate functions make to the new venture. Without the economic benefits these
contributions provide, there is simply no reason for the venture to exist within the parent.
One might ask whether this necessary connection between the original business and its
subsequent entry into new businesses produces a single, deterministic path of expansion
from one industry into another. For example, oil companies have virtually en masse
diversified into petro-chemicals, primarily to take advantage of economies of supply,
logistics and the management expertise in operating large scale processing facilities. Do
we find this kind of industry-to-industry expansion path is the same for all industries in
every country?
The answer is no; we need to specify which nation we are examining. That is,
industry-to-industry diversification patterns vary substantially across countries. These
differences exist even though the businesses in the diversifying firms in each country are
related through sharing resources or capabilities. 11
The reason for such differences is that the opportunities for diversification in each
country are to a large extent determined by institutional factors, and the strength and
character of these factors are specific to each nation. The costs of diversification into a
27
new industry will in general be higher depending on the degree to which incumbents are
organized to protect their turf. Stronger institutional forces will raise entry barriers.
Forces such as regulation, industry associations, labor involvement in the governance of
firms as found in Germany, and relationships among owners of incumbent firms, will be
powerful for some industries and weaker for others in any country. Variation in these
forces across nations will therefore skew the opportunities available to any firm
attempting to grow through diversification and therefore create different country-specific
expansion paths for firms in the same original industry.
It is important then not to assume that diversification patterns will be globally
uniform. Nor is it wise to assume that there is only one industry into which a firm must
diversify in order to realize gains through economies of scope in combining activities
across businesses. There are in fact many possible industries into which a firm might
diversify in order to achieve these economies. Which new industries are chosen
systematically is in part a function of the structure of opportunities presented by nationspecific institutions.
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Summary

Every diversification event involves entry into a new industry.

The contribution of the firm’s resources and capabilities to the new venture
is central for achieving and defending its competitive advantage.

When the potential of its initial business wanes, a firm begins to search for
other markets to apply the skills and resources it has developed.

There are two general types of new market opportunity: a new geographical
region or a new product market involving a new technology, a new set of
customers or both of these.

Establishing new businesses rarely solves the firm’s economic problems in
its core business.

As a firm begins to think about diversification, it can ask two questions:
what is the new business going to do for the firm? What is the firm going to
do for the new business?

There are a variety of contributions the venture can make, including:
corporate reduction of systematic risk, corporate growth in revenues or
earnings, and favorable repositioning of current businesses.

There are in general five types of contribution the corporation can make to
the new business: financial capital; resources, such as distribution channels
or brand equity; capabilities in activities such as marketing or operations;
entrepreneurial management skills in growing or revitalizing businesses;
general management skills in managing larger businesses.

The diversifying firm should ask whether its current businesses have
resources and capabilities that allow the new unit to position itself more
effectively than rivals.

All inputs of the firm to its businesses can be seen as alternatives to inputs
offered in the market.

An important way to think about leveraging resources among business units
and benchmarking these resources against market alternatives is economies
of scope.

Economies of scope are achieved when the firm is effective at coordinating
the joint execution of specialized activities shared by both the firm's
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incumbent business and its new venture, and this performance is superior to
that possible in the market.

The paradox of transferring a key capability from the old to the new
business is that the more useful they are to the venture, the less transferable
they are likely to be.

Management experience within the parent corporation that is relevant to the
growth of the new business and can be shared is a potentially valuable
capability for the venture's expansion.

Core competence is the existence of a generative technology platform
shared across business units and the ability to develop new businesses based
on the innovations produced.

Some corporations specialize in building businesses by emphasizing either
cost advantage or value advantage.

An attractive market opportunity has a high ultimate size, high future
growth rate and a future market structure that favors the new business.

In most firms, the current strategy is the lens through which all proposals
for new investments are assessed.

The two major challenges for the firm in managing the new venture
development process are differentation and integration.

Industry-to-industry diversification patterns vary substantially across
countries because of differences in institutional factors that determine
market opportunities.12
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Endnotes
See Yakov Ahimud and Baruch Lev, “Risk reduction as a motivation for conglomerate
merger,” Bell Journal of Economics, Autumn, 1981; Peter Lane, Albert Canella and
Michael Lubatkin, “Agency problems as antecedents to unrelated mergers and
acquisitions: Amihud and Lev reconsidered,” Strategic Management Journal, 19, 1998.
2
See Jay Barney, “Strategic factor markets: Expectations, luck and business strategy,”
Management Science, 32:1231-1241, 1986.
3
See Richard Makadok, “Towards a synthesis of the resource-based and dynamic
capabilities based views of rent creation,” Strategic Management Journal, 22:387-402,
2001; for empirical support of this argument see, Laurence Capron, “The long term
performance of horizontal acquisitions,” Strategic Management Journal, 20:987-1018,
1999.
4
For a study that examines the relative advantages of receiving value from the new unit
as opposed to giving value to it, See Laurence Capron, “The long term performance of
horizontal acquisitions,” Strategic Management Journal, 20:987-1018, 1999.
5
For a detailed description of Dupont’s diversification into paints, see Alfred D.
Chandler, Strategy and Structure, Cambridge MA: MIT Press. Chandler’s book remains a
classic text on the management of diversification.
6
See C. K. Prahalad and Gary Hamel, “The core competence of the corporation,”
Harvard Business Review, May, 1990.
7
See Birger Wernerfelt and Cynthia Montgomery, “What is an Attractive Industry?”
Management Science, 32: 1223-30, 1986; Birger Wernerfelt and Cynthia Montgomery,
“Tobin’s q and the Importance of Focus in Firm Performance”, American Economic
Review, 78:246-50, 1988; Lois Shelton, "Strategic Business Fits and Corporate
Acquisition: Empirical Evidence, Strategic Management Journal, 1988, 9:279-287, 1988.
8
See Henry Christensen and Cynthia Montgomery, “Corporate economic performance:
diversification strategy vs. market structure,” Strategic Management Journal, 2:327-343,
1981.
9
See Yves Doz, Reinhard Angelmar and C. K. Prahalad, “Technological innovation and
interdependence: A challenge for the large, complex firm,” Technology in Society, 2/3:
105-125, 1985.
10
Jeffrey Allen, “Capital markets and corporate structure: The equity carve-outs of
Thermoelectron,” Journal of Financial Economics, 48:99-124, 1998.
11
See Bruce Kogut, Gordon Walker and Jai-deep Anand, “Agency and institutions:
National divergences in diversification behavior,” Organization Science, February, 2002.
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