What is Equity Strategic Alliance?
An equity strategic alliance is a strategic alliance in which a firm purchases equity in another firm, thus shares a partial ownership of the firm.
This type of alliance focuses on combining some of the firms’ resources, thus creating a competitive advantage. Typically, the larger firm in equity alliances has more cash flow, a lower debt ratio, a stronger interest coverage ratio, a higher profit margin, and ROA than the smaller firm.
A non-equity strategic alliance is usually promoted to an equity alliance after a period. The intermediate non-equity partnership can be designed to lengthen the tenure of the relationship while provide some capital to the partners.
In the past, although non-equity strategic alliances account for a majority of alliances across industries, equity arrangements are not an uncommon choice when forming alliances. Recently, there has been a dramatic increase in the number of equity alliances.
Why Do Equity Strategic Alliances Exist?
The first reason firms form equity strategic alliance is to create a competitive advantage. This happens because the alliance can help firms refocus their strategy due to new resources and capabilities.
The second reason firms form equity strategic alliance is to pursue an opportunity that is too uneconomical, complex, or risky for a single firm to proceed alone.
The third reason firms form equity strategic alliance is because it is challenging to pursue other types of alliances, such as non-equity.
This is because it may be difficult to write a contract that specifies the exact contribution of each partner to the alliance or allocates the output and profits fairly. When contracts are incomplete, each partner has less incentive to invest because they would fear opportunistic behaviors by the other firm.
Through equity ownership, the costs and benefits of designing, manufacturing, and marketing the product can be proportionally shared.
The fourth reason firms purchase an equity stake in other firms is to prevent differential bargaining power. When there is a significant disparity in the bargaining powers of the partners, the larger firm may force renegotiation of terms after the initiation of the strategic alliance.
Cross-ownership of equity or equity investment by the larger firm may enable the firms to resist opportunism. Thus, the costs of opportunism might be minimized when there are equity linkages across the partners.
How Do Equity Strategic Alliances Work?
In exchange for the equity interest, the firm is required to join a partnership and contribute a lump sum of capital. These equity investments are typically made through a direct purchase of shares in the firm.
The firm then receives the right to vote on governance matters.
The capital is held for the duration of the tenure. Upon exiting the partnership, the firm can reclaim this contribution.
Types of Equity Strategic Alliances
In a partial acquisition, a firm purchases a minority equity stake of another firm.
This can allow a company to offer financial support by purchasing a portion of equity of the other firm, and in return earning control on a portion of its business operations.
The bigger firm in a partial acquisition is most often the buyer of equity in the alliance.
In a cross-equity transaction, each of the firms purchases equity of the other.
This can help firms to gain a certain degree of control over the business operations of each other.
Effective Situations to Firm Equity Strategic Alliances
- Equity is more likely to be used in industries where the uncertainty about the output from the strategic alliance is high, such as R&D or technology. Recently, these industries are becoming more and more common.
- Equity alliances are more likely to be used to pair firms of different sizes, market powers, or growth options.
- Equity stakes provide financial means to the capital-constrained partner in the alliance. These partners are usually severely capital-constrained with little debt capacity, while the buying firms have significantly more cash and are less liquidity constrained.
Cooperative Moves of Equity Strategic Alliances
This type of strategic alliance consists of the following cooperative moves: (1) research and development partnerships, (2) cross-distribution agreements, (3) cross-licensing agreements, (4) cross-manufacturing agreements, and (5) joint-bidding consortia.
Typically, firms enter research and development partnerships when they have some knowledge of different aspects of a particular technology and decide to share their know-how through the formation of a strategic alliance. By joining the alliance, firms hope to design and develop an actual, marketable product or service.
Resources
Further Reading
- Strategic Alliance: What is it, Types, Benefits & Why You Need it (workspan.com)
- Evolving Partnership Economics: The Equity And Non-Equity Models Are Starting To Blur (abovethelaw.com)
Related Concepts
References
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2016). Strategic Management: Concepts: Competitiveness and Globalization (12th ed.). Cengage Learning.
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2019). Strategic Management: Concepts and Cases: Competitiveness and Globalization (MindTap Course List) (13th ed.). Cengage Learning.
- When is Equity More than Just Financing? Evidence from Strategic Alliances. (2021b).