Focus On Equity And Non-Equity Entry Modes

The current body of literature often used firm size to describe its relationship with entry modes. However, the big obscurity about the definition of firm size is remarkable. This research will study the influence of industry specific factor on the entry mode decision, considering the characteristics variables. These variables are divided into four variables, which are technology, growth, capital intensity and concentration level in relation to the resource based view.

The first group are the tangible resources. The aspects studied within this group are the number of employees and factory size and equipment. Employee count is a logical definition of firm size, however researchers studying its relationship with entry modes found mixed and even contradicting results. This study therefore concluded that there is no significant evidence about the influence of firms number of employees on entry mode selection. Factory size and equipment are often used to determine size and are characterized by their asset specificity. Looking at its relationship with entry modes it became clear that firms with excess tangible resources prefer high control entry modes to protect themselves against the threats of asset specificity. The second group are the intangible resources, which are divided into marketing and technological resources. These resources can be found within employees (e.g. information, knowledge or skills) and are also used in existing literature to determine firm size. When a firm is characterized by excess marketing resources it will likely prefer high control entry modes, just like firms with excess technological resources, unless a rapid process of internationalization is desired. The last group, financial resources, can be divided into internally generated and externally raised financial resources. These two types of financial resources have shown an opposing relationship regarding entry modes. Firms using internally generated resources often have more confidence and will therefore prefer high control modes. On the other hand, firms with excess externally raised financial resources will prefer lower risk entry modes, which is a characteristic of low control modes. The moderating effect of firms need for size, determined by industrial characteristics, may influence the earlier conclusions. The strength of this moderating effect is mostly determined by the level of risk and uncertainty of the targeted industry. The higher the risk and uncertainty, the higher the preference for low control entry modes

INTRODUCTION

This bachelor thesis is written as the requirement to complete the Bachelor of Science at Tilburg University. A literature reasearch has been conducted, which contributes to the existing literature in the field of organization and strategy. Firstly, the introduction will provide an overview of the topic and the problem to be studied.

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I.1 PROBLEM INDICATION

Differences between SMEs (Small and Medium Enterprises) and MNCs (Multinational Companies) are seen not only from the structural aspects of both enterprises but also from the decision making of entry mode choice (Erramilli and D’Souza, 1993). Extensive research has been conducted on the topic of entry mode choice and internationalization. Even though much of the research taks about entry mode choice, Brouther and Hennart, (2007) stated that most of the studies in entry mode choice focus more on the multinational firm, instead of on SMEs.

The most common theories explaining the entry mode choice for SMEs are transaction cost theory, resource-based view and institutional theory. However, the knowledge about this field scattered. Some scholars have already examined the entry mode choice in SMEs: for example, Brouthers and Nakos (2004) found that the transaction theory can be applied to explain the entry mode choice of SME and that there is no relationship between entry mode choice and firm size while other researchers found that the size does matter. On the other hand, Dickson, Dicson et. Al. (2006) use the extended of resource based view to explain behavior in SME related to the institutional environment and its opportunism. Instead of looking at the differences between these theories, it will be better to combine these three theories to explain the SMEs’ entry mode choice.

In understanding the internationalization process in SMEs, scholars must consider the external and internal factors that structure the pattern SMEs its entry mode choice. Since Brouther and Hennart (2007) show how many studies prove that most industrial sectors are exposed to international competition nowadays, this research will focus on the external factor, which is the industry-specific characteristic.

The term “industry” is commonly defined as the grouping of individual companies into classification based on the same characteristics related to product type, production technology and market attributes (Bother & Holmquist, 1996). Existing literatures show that these industry characteristics may have a direct impact on a firm’s choice of entry strategy, though how the firm effects this decision still needs to be formulated precisely. Nowadays, firms must consider technology when entering a particular industry. Some researchers including Li and Qian (2008), have suggested that technology does have a different impact on SMEs than on larger companies in their choice on entry strategy. In addition, Desh and Beard (1984) determined that industry growth also influences the extent to which organizations attempt to manage interde-pendencies and complexities thus it is related to business strategies. Capitall intensity is another suggessted industry effect which affects the entry mode strategy along with the R&D intensity as the result of technological development (Pan and Tse, 2004). Entry mode study shows that in term of competition, the behavior of a firm in entry mode study is affected by other firms in its industry, both its domestic rival and incumbents (Brouther and Hennart, 2007). This effect shapes the degree of concentration level in its industry. Therefore, adding the concentration level as the last variable is important in examining SME’s entry mode choice.

Hennart’s the distinction between equity and non-equity entry mode (1988a, 1989, 2000) is a good insight to study the SMEs’ internationalization process in entering new industry. Williamson (1985) suggests that companies adopt a certain structure — markets (non-equity modes) versus hierarchies (equity modes) — based on how efficient one structure is compared with the alternative structure. This choice is also defined by Pan & Tse (2000) as the first level of entry mode decision, where SMEs must deal with its limited resources and capabilities. In addition, at the macro level at which industry factors come into play, the impact of this type entry mode choice is high (Pan and Tse, 2000). Thus, the following research wil concern itself with the choice between these two strategies.

I.2 PROBLEM STATEMENT

The central question to be answered in this research is:

What is the impact of industry characteristics on SMEs’ entry mode choice between equity (JV and WOS) and non-equity (contractual agreements and exporting activities)?

I.2.1 Definition

In order to avoid misinterpretation, the definitions of key terms in the problem statement are as follows:

Small-and-Medium Sized Enterprises (SMEs): This type of enterprise is characterized as resource constrained, lacking market power, knowledge and resources to operate viably in international markets (Fujita, 1995; Coviello and McAuley, 1999; Knight 2000; Hollenstein, 2005). SME may engage in variety entry modes which vary significantly with respect to benefit and cost (Sharma and Erramilli, 2004).

Dependent Variables: Equity and Non-Equity Entry Mode

According to Decker and Zhao (2004), equity and non equity (contract) entry mode are distinguished form each other based on the resource commitment level. JVs and WOS are classified as the equity entry mode, while the contractual agreement and exporting activities are part of the non-equity. Considering an equity entry mode over non equity requires time and risk due to the greater chance of failure and diversifying risk by themselves (See APPENDIX 1).

Independent Variables: Industry characteristics

Technology: Firms in high technology industry are characterized by short product recycle, violent market dynamics and high promotional spending (Segers 1993; Stuart 2000). In high-technology industry, fast product replacement frequently occurs (Qian and Li, 2003), which leads to changes in market demand structure and competition structure (Deeds, et al. 1999). Porter (1985) argues that create market awareness is important in high-technology industries. Hence, investing in heavy R&D and promotion are required to cover the high risk associated with the high investment.

Growth: In a high-growth industry, many firms will experience resource munificence, generated by the constantly increasing revenues and opportunities (Cyert & March,1963; Dess & Beard, 1984). On the other hand, low-growth industries, such as utilities, depend upon stability and reliability (Gordon, 1985). Industry growth also influences the extent to which organizations attempt to strategically manage interde-pendencies and complexities. (xxxxx)

Capital Intensity: Capital Intensive Industry refers to an industry which requires a substantial amount of capital for the production of goods. As the capital intensity of capital intensive industries result in higher level of productivity, these industries possess the power to generate more income and thus more profit.

Concentration Level: a high concentration of market share is held by the largest firms, an industry is deemed concentrated. With only a few firms holding a large market share, the landscape is less competitive and closer to a monopoly. A low concentration level indicates that the industry is characterized by many rivals, none of which has a significant market share. These fragmented markets are said to be competitive. The concentration ratio is not the only available measure; the trend is to define industries in terms that convey more information than the distribution of market share.

I.2.2 Theoretical Approach

Entry mode choice rely heavily on transaction cost theory and resource based view. When firm decide to enter new market, they consider the cost and resource required to sell and service their product effectively in foreign market (Susman and Stites, xxx ). Institutional theory. Thus, this research will use a combination transaction cost theory, research based view and institutional theory in relation to industry characteristics:

– Transaction Cost Theory

The two main costs that this theory examines are market transaction costs and control costs (Williamson, 1985; Hennart, 1989; Williamson & Ouchi, 1981). Williamson (1985; Williamson & Ouchi, 1981) also suggests that frequency of interaction is an important determinant of transaction costs, however in entry mode studies transactions are considered continuous thus precluding the need for separate measure of frequency (e.g. Brouthers & Brouthers, forthcoming; Erramilli & Rao, 1993).

While a company can protect its proprietary know-how and minimize its market transaction costs by integrating its foreign operations, it also has to balance the need for integration with the costs of controlling the hierarchical structure (Erramilli & Rao, 1993; Hennart, 1989). According to Hennart (1989, p. 215) “a shift to hierarchy means that one of the parties to the exchange becomes an employer [subsidiary] to the other.” As a result the party (the new subsidiary) is not rewarded for market performance, but for following internal managerial orders. This increases the internal control costs of the organization because the firm may incur significant bureaucratic costs in controlling the new operation. Because of these increased control costs, hierarchical equity modes of organization structure are not always superior to market-based non-equity forms. Only when internal organizational costs are lower than market transaction costs will it be efficient for a company to organize itself as a hierarchy (Hennart, 1989). Consequently, firms tend to select entry modes that balance the advantages of integration with the additional costs of control.

Transaction costs include environmental and behavioral uncertainties, opportunism, and asset specificity (Rindfleisch and Heide 1997). Environmental and behavioral uncertainties imply the unpredictability of market changes and firms’ actions or reactions (Heide and John 1988). Such unpredictability makes the constraints by contracts that specify every eventuality and consequent response less effective (Heide 1994). Opportunism can be defined as self-interest seeking with guile (Williamson 1985). Asset specificity implies that commitments between partners are transaction-specific assets that cannot be redeployed easily (Williamson 1985). Transaction costs can be much higher in high-velocity foreign markets (Leonidou et al. 1998). High market velocity associated with international trade, such as exchange rate fluctuations, adds to the environmental unpredictability and thus increases the difficulty to specify partners’ responsibility in contracts (Gray and Chan 2001; Wortzel and Wortzel 1996). Therefore, if a firm develops firm-specific advantages, such as product innovations or high-quality brands, it should resort to self reliance equity entry rather than partnerships like contractual agreements (Anderson and Gatignon 1986; Fein and Anderson 1997). Transaction cost theory illustrates the necessity of equity entry in high-velocity foreign markets when a firm develops firm-specific advantages. Greater asset specificity is supposed to lead to equity entry mode choices. Transactions that involve intermediate asset specificity will be efficiently governed by equity entry, whereas those characterized by high asset specificity will make use of WOS (Brouthers and Hennart 2007).

– Resource Based View

The resource-based view of the firm originates from the work of Penrose (1959) work, where the firm is described as a bundle of resources. Penrose posits that the growth of the firm is both facilitated and limited by management search for the best usage of available resources. Barney (1991) provides a precise and formalized description of this perspective. Resources include assets, capabilities, processes, attributes, knowledge and know-how that are possessed by a firm, and that can be used to formulate and implement competitive strategies. The resource-based view relies on two fundamental assumptions: that of resource heterogeneity (resources and capabilities possessed by firms may differ), and of resource immobility (these differences may be long lasting) (Mata, Fuerst and Barney, 1995). If a resource possessed by a firm is also possessed by several of its competitors (no heterogeneity), this resource cannot contribute to competitive advantage. Heterogeneity is needed obtaining at least temporary competitive advantage; resource immobility is needed to sustain competitive advantage, since competitors would face cost disadvantage in obtaining, developing, and using it compared to the firm that already possesses it.

Following Penrose (1959), the resource-based view aims to understand how resources help firms to sustain their competitive advantage and aims figure out how that competitive advantage can be systematically created. Resource-based theory suggest that firms develop resource-based advantages by developing or acquiring a set of firm-specific resources and capabilities that are valuable, rare, and imperfectly imitable and for which there are no commonly- available substitutes (Barney 1991). As such, firms develop unique resources that they can exploit in foreign markets, or they use foreign markets as a source for acquiring or developing new resource-based advantages (Brouthers and Hennart 2007). Both equity modes and non-equity modes can help firms to develop or acquire these resource-based advantages. By contractual agreements and export, firms can pool unique resources from different partners and combine them into “core competencies” that are difficult to duplicate (Hamel and Prahalad 1994). JV and WOS, on the other hand, protects unique resources from leakage and consequent duplication (Grant 1991). Resource-based theory suggests that innovations are important in fast-moving industries as they make innovators unique from other players (Barney 1991). These non-equity modes can be a double-edged sword to develop and sustain innovative advantage (IA) in foreign markets. On the one hand, contractual agreements likes alliances and license enhance a firm’s innovation capabilitiesas partnerships facilitate the process of learning from local partners who know their home markets better (Hitt et al. 1997). Resource-based theory illustrates the importance of sustaining firm-specific advantages. However, it does not consider the differences between firms in terms of organizational attributes. It is not clear whether large firms and small firms can use the same means to develop and sustain firm-specific advantages. Therefore, Brouthers and Hennart (2007) suggest future studies should combine the resourcebased view with other perspectives to advance our knowledge of entry modes.

I.3 RESEARCH QUESTION

Industry characteristics will act as focus in this research. It leads to the following research questions derived from the problem statement:

What is the influence of technology on SME’s equity entry mode decision?

What is the influence of growth on SME’s equity entry mode decision?

What is the influence of capital intensity on SME’s equity entry mode decision?

What is the influence of concentration level on SME’s equity entry mode decision?

1.4 RELEVANCE

Much literatures on SME and its relation to the entry mode decision only discuss in a specific theory and/or factor. This study is meant to offer new insights and contributions to the existing literature in order to describe the process of decision-making whenever SME chooses equity instead of non-equity as their first level entry mode choice. Moreover, the specification and limitation in the field of industry characteristics is important to reach deeper understanding in the decision process of SME entry mode strategy.

From the managerial perspective, if an entry mode decision is considered an important strategic decision and “the success of SME’ under globalization depends on the formulation, in large part, and on the implementation of the strategy” (Knight, 2000, p13), the strategic behavior of smaller companies must be investigated. The result also proviide insight for managers aiming to position their firm within an industry.

1.5 RESEARCH DESIGN AND DATA COLLECTION

This section will present descriptive research, beginning with an explanation about the nature of SME. This research will also discuss and elaborate the differences between choosing either equity or non-equity as an entry mode. This research will also explain industry characteristics as one of the considered variables that would affect the SME’s choice of entry mode strategy. Even though this descriptive research will focus on a literature review of the considered variables in relation to the trasactional cost, resource based view and institutional theory, the aims is to offer insights into why SME would likely to choose equity instead of non-equity as their entry mode based on the industry characteristics.

This report collects data from secondary data source, using online databases, for example from JSTOR, Science Direct and ABI/inform. Many articles and journal related to this topic will be paid attention especially the recent, up dated and cited articles. There are two journal examples titled “Journal for international Business Studies” and the “Journal of Management” which are going to be used for this report and are taken from the high quality journals available through the University’s information portal for Strategic Management students writing their bachelor thesis. The use of these articles involves advantages and disadvantages. One of the benefits is that a researcher can access all relevant articles published within these high quality journals between 1985 and the present. However, many relevant articles published in other journals will not be found using this database. In conclusion, in order to obtain more information about certain subjects, researchers should follow the citations in these articles to gain a broader understanding of the current literature.

1.6 STRUCTURE

Chapter Two will examine the influence technology has on the SMEs’ entry mode decision will be studied. Subsequently, Chapter Three will look at the influence of growth on the entry mode decision. The influence of capital intensity to SME’s entry mode will be addressed in Chapter Four, and the influence of the last variable, concentration level, will be discussed in Chapter Five. Finally, Chapter Six will review the general conclusion, limitations and recommendation for both managers and future research. The answer of the problem statement will be given here.

II. Technology and SME’s Entry Mode Choice

Li and Qian (2008) define that high-tecnology industry substantially characterized as invest heavily on R&D intensity, products life cycle and market dynamism. The short product life cycle means only the first movers can reap the maximum profit (Segers, 1993). Consequently, firms must invest heavily on R&D intensity in order to innovate ahead of their competitors (D’aveni, 1994) and to sustain competitive advantage. Thus, in high-technology industries, firm embrace innovative advantage as their key success (Porter, 1985). In addition, new products in high technology industries are usually expensive, because innovators wish to cover their heavy R&D costs and grab reasonable profits before their innovations become obsolete (Porter 1985). Consequently, innovators have to spend substantially on promotion to educate customers and overcome customer hesitation. Without wide market awareness, innovators can hardly achieve rapid sales growth before their innovations become obsolete (Qian and Li 2003a).

Larger firms have a greater variety of options than small firms in terms of resources, capabilities and power, although their activities, too, are constrained by personal and institutional factors. Unlike large companies which have the resources to produce innovation, SMEs deal with the resource constrain. They have to develop their own distinctive competences to enable them compete against large firms (Etemad, 2000). Equity entry mode such as wholly owned subsidiaries and joint ventures may not work well for SMEs, since it requires high investment and funding. SME may not be able to cover such huge funding for high R& D intensity. Despite their financial limitation, by making the contractual agreements, SME have opportunity to learn and grow. Moreover, Burgel and Murray (2000) found that the young firm in the early stage of its development operates in a high-technological industry by considering the entry process as the commitment to internalization as a function of experiential knowledge of foreign market.

For MNCs, equity entry modes can be the optimal option to manage violent market dynamism. MNCs have strict control over their R&D and production(Heide 1994). Such strict control facilitates coordination between different activities located in different countries (Hill and Kim 1988). Thus, MNCs can take their innovations to the markets at a faster pace. In addition, when new generations of products emerge in the market, MNCs, with strict control over R&D, production, prices, can upgrade their existing products and drop prices, to prolong shelf-life. Moreover, due to the larger economies of scale and market imperfections across countries, internalizing MNCs enjoy cost advantages over new products. All of these benefits help MNCs to extend the life span of their products and reduce the effects of market dynamism.

Transaction cost theory suggests that equity entry modes save costs for MNCs. Through wholly owned subsidiaries, MNC avoid coordinating with foreign partners, prevent leaking important R&D information to competitors, and protect themselves from possible opportunistic acts by foreign partners (Hitt et al. 1997). In contrast, coordinating with foreign partners slows down the innovation process. R&D knowledge leakage and partners’ opportunistic acts can lead to duplication by competitors. With violent market dynamism, these high transaction costs can lead to market failure. In contrast, non-equity entry modes provide the optimal option for SMEs to manage the high environmental velocity in high technology industries.

Transaction cost theory suggests that equity entry mode such as wholly owned subsidiaries and joint venture be too costly and complex for SMEs to handle when there is high market dynamism. Internalized operation in overseas markets incurs high coordination costs, distribution costs, and management costs among units that are located in different countries and demands high coordination, distribution, and management competencies (Williamson 1985). Differences that are encountered across countries and currency value fluctuations across countries add to the costs and difficulties (Wortzel and Wortzel 1996). High market dynamism greatly enhances these costs and demands. The size constraints that are associated with SMEs restrict their information-collecting and informationprocessing capabilities and thus make internalization too complex and too costly for SMEs to manage. Due to the industry’s market dynamism, high-tech industry require high adaptation and application of knowledge. Thus, the preferences to entry mode choice are characterized by relatively low resource commitment.

Unlike MNCs, SMEs may not be able to absorb the high risks that are associated with high market dynamism in technology industries. From the resource-based view, partnerships help firms to pool different resources or distinctive capabilities from partners in different countries (Hamel and Prahalad 1994). Such sharing of different resources or distinctive capabilities enhances the competitive advantages of the group. The logic that is described above suggests the following hypotheses.

H1. In a high-technology industries, the greater propensities for SMEs to choose non-equity entry mode strategy.

III. Growth and SME’s Entry Mode Choice

McDougal et. al. (1994) states that an industry’s growth rate has been a key component of market attractiveness for both newventures and established firms. Growth has served as an indicator of disequilibrium (Yip, 1982), a condition favorably associated with entry (Yip, 1982; Porter, 1980) and as an indicator of industry evolution (Sandberg, 1986). Explicit in many prescriptions offered by both new venture researchers and venture capitalists for venture success has been entry into a high growth industry. When asked to determine the most important criterion in deciding which new ventures to fund, venture capitalists in MacMillan,Siegel, and Narasimha’s (1985) study identified a high industry growth rate as the critical market requirement.

Rapidly growing and unstable industries, which pose more sources of uncertainty than stable industries (Hambrick & Finkelstein, 1987), often require a wider range of competitive actions to address uncertainties. In addition, Porter (1980) argues that rapid industry growth ensures that incumbents can maintain a strong financial performance even though a new entrant takes some market share. Thus, new ventures entering into rapidly growing industries would provoke less retaliation by incumbent firms. Consistent with Porter’s argument, Miller and Camp’s (1985) research on the selection of markets to enter suggested that managers should look for situations in which high market growth can potentially reduce the effect of competitive pressures.

Hause and Rietz (1984) found significant statistical evidence that new firm entry is positively related to the industry growth, since it is related to profit oriented. Thus, firm will tend to reduce risk by limiting the resource commitment. In a high-growth industry, many firms will experience resource munificence, generated by constant increase of revenues and opportunities (Cyert & March,1963; Dess & Beard, 1984). On the other hand, low-growth industries, such as utilities, depends on stability and reliability (Gordon, 1985).

Based on transaction cost theory, the cost will be higher in high-growth markets. Therefore, if a firm develops firm-specific advantages, such as product innovations or high-quality brands, it should resort to equity instead of partnerships like contractual agreements (Anderson and Gatignon 1986; Fein and Anderson 1997). In contrast to larger firms, SMEs perceive limited capacity means that for SMEs resource dependency rather than resouce sufficiency often is the norm (Calof, 1993), requiring them to seek out cooperative linkage with firm possessing the requisite rources (Dickson et. Al, (2006). A resources-based view suggests that the competitive advantage can be sustained if the firm has the ability to compete. However, a firm should joint with another expert firm to develop its own knowledge and ability. According to institutional theory, a firm can minimize risk in high growth industry by taking non-equity modes that requires the low resource commitment such as a contract. Thus, the following hypothesis is offered:

H2. The slower the growth within the industry, the higher SMEs’ propensity to select equity entry mode.

IV. Capital Intensity and SME’s Entry Mode Choice

Capital’ proportion involved in the Capital Intensive industries is much higher than the proportion of labor. This is the reason why the industrial structure and types of industries require high value investments in capital assets. Generally, the capital intensive industries generate high level of profit. The large amount of capital invested in these industries produce high rate of return and this in turn leads to more capital investment. Given that efficiency is typically emphasized as a key success factor in capital-intensive industries, competitive actions that reflect a focus on efficiency are likely to be associated with better firm performance in such industries (Hambrick & Lei, 1985). However, a firm in a capital-intensive industry is generally committed to a course of action as capital intensity often creates rigidity; new products or markets cannot be accommodated as deviations might prove expensive (Hambrick & Lei, 1985).

Capital intensive industries involve high level of fixed cost. For this reason they involve higher degree of risk. If the sales volume declines, profits earned by the industry will experience a sharp decrease as the fixed cost part cannot be removed or reduced. So, if market demand declines, then the capital intensive industries will not be suffer from more loss compared to the labor intensive industries. According to Porter (1985) high fixed costs result in an economy of scale effect that increases rivalry. When total costs are mostly fixed costs, the firm must produce near capacity to attain the lowest unit costs. Since the firm must sell this large quantity of product, high levels of production lead to a fight for market share and results in increased rivalry. Automobile industry, chemical industry and oil refinery industry are basically capital intensive industries, which require large capital investment for starting up the business and to run the business as well. Due to the fact that all capital intensive industries require large volume of financial resources for starting up, the number of newcomers to any c