When you look to external partners for acquiring resources and capabilities, your organization needs a practical roadmap to answer some critical questions: What kind of business partnerships and combinations do we need? How will we manage them over time? What profits will we earn, and will they justify our investment?

Ben Gomes-Casseres, international business scholar and Powerlinx adviser, addresses these questions and more in The Remix Strategy: The Three Laws of Business Combination. This excerpt, originally posted by the Harvard Business Review offers a simple, but powerful, framework to help you make those decisions.

Business is being turned outside-in. Acquisitions, mergers, joint ventures, alliances, partnerships, and other business combinations are no longer exceptions for most firms — they have become central to gaining competitive advantage. This combining of assets, capabilities, markets, and talent pools to create new value is what I call the remix strategy — and it is critical today to do this remix right.

Most likely, you have considered one or several remixes for your business. The key strategic questions you face are not whether combinations such as these are necessary but, rather, how will they create value, and how are you going to capture that value? How are these ventures going to enhance your competitive position? Whether you are at the top of the company driving the remix strategy, in the middle managing an acquisition or a partnership, or among the operating ranks keeping the pieces humming, you need to know the answers to such questions.

In my work with executives, I’ve noticed a distinct gap in their tool kits. Managers already have a great deal of information and best practices for implementing alliances and acquisitions. The strength of these playbooks is their concrete detail about the legal, managerial, and financial ins and outs of every deal type and the tips on how to manage people and cultures in these combinations on a day-to-day basis. But managers lack a set of guiding principles for actually making the deal create value for the company. Based on my 30 years of consulting, teaching, and academic research on partnership strategy, I have created a simple but powerful framework to help executives see clearly the key decisions that drive value creation and capture, and then to navigate those decisions successfully. I call these guiding principles the three laws of business combinations, also known as “The Remix Strategy”.

The Three Laws of The Remix Strategy

Successful business combinations — those that turn out to be a profitable use of resources — all follow the three laws. These laws are not formulated as commandments or orders, but are necessary conditions for success. All business combinations must have the potential to create joint value, must be governed to realize this value, and must share value in a way that provides a reward to each party’s investment in the remix strategy. Each law points to a set of practical implications:

• First law: The combination must have the potential to create more value than the parties can alone. The first law asks these practical questions: How much more value can we create in the market together? What specific resources must we combine to create this value?
• Second law: The combination must be designed and managed to realize the joint value. Which partners and structures fit this goal best? How do we manage the risk and uncertainty inherent in such combinations?
• Third law: The value earned by the parties must motivate them to contribute to the combination. How do we divide the joint value created? How will value be shared over time?

Taken together, these three laws provide a powerful, systematic approach for creating and capturing value from your partnerships—from when to form a combination, to how to manage collaboration, to how to ensure that you get a return on your efforts.

These three laws of the remix strategy determine the success of any business combination, and at first glance, they’re easy to grasp. But each is deeper than it looks. And living by them is tricky in practice. Often, one or the other gets short shrift in the rush to strike a deal or gets lost in the glare of a promising future. Another practical problem is that because each law revolves around a different school of thought in strategy and management science, experts in one area can easily miss cues in another and, in doing so, inadvertently plant the seeds for a costly retreat later on. To avoid these pitfalls, we will need to dig deeper into each one of the laws:.

First Law: Identify Potential Joint Value

In casual conversation, the idea of creating value in combinations is often expressed as 1 + 1 = 3, or some such mathematical metaphor. In fact, that isn’t a crazy way to think about the three laws of the remix strategy.

As explained, the first law for a business combination is that the remix strategy must have the potential to create more value than the resources can generate when governed separately, that is, without being combined. In common business language, the combination has to produce synergy. I hesitate to use that term because of its reputation as a business buzzword. But the bad rep comes from ignoring the complex processes involved in creating value in combinations. To actually produce synergy and achieve real results, you need to pay attention to all three laws.

For example, how much more value is created by the combination in the remix strategy? In our metaphorical formula, the extra value is 50% (3 is 50% greater than 2). But in a real situation, what is the actual amount of extra value created? That variable is clearly worth pinning down before you launch any new combination. If the increased value is great, then the risk of outright failure is probably lower and there will be more extra value to share in the third law. If the increased value is small, then everything must go right for the combination to pay off— governance must be optimal and setbacks must be minimal. Furthermore, with such a narrow margin of error in the combination, a lopsided division of gains could well leave one party earning less from the combination than it would if the party kept its assets separate. Consequently, this party would be less likely to want to commit to the combination.

And there is an even more fundamental question: How do you even measure value in this context? The numerical metaphor makes it looks easy to add and compare values. But in fact, the benefits of a combination may come in various forms — from added cash profits or lowered costs to added learning or sustainability of an advantage. And not-for-profit partners will usually value outcomes differently still. Similarly, the inputs, or contributions, are also valued differently — these could be cash, technology, know-how, and so forth.

In the abstract, you might think that all the benefits sought and the contributions made affect shareholder value or the market capitalization of a firm. But the steps from strategic benefits to market valuation are, in themselves, usually rough estimates at best. Furthermore, each partner may perceive the benefits from any given combination differently. One partner may estimate an outcome of 3 when the other sees only 2.5. Such differences may get resolved in the negotiation over the distribution of gains, but they make the initial evaluation of joint value murky.

To address these kinds of ambiguities, you need to focus concretely on the economic and competitive mechanisms that will drive the creation of joint value. This calls for fundamental strategic analysis. Why would combining resources yield an added benefit? What new competitive advantages are generated by the combination? Does it matter how the resources are combined? Which key levers affect the amount of value created by the combination?

Second Law: Govern the Collaboration

The second law of business combinations is that they must be implemented in a way that creates joint value in reality, not just on paper. In other words, the combination has to act as an integrated operation in those areas that count for value creation. We might summarize this law as 1 + 1 = 1, referring now to unity in the management of the combination, not to its economic rationale.

Effective governance means more than ensuring that the parties get along at the personal level or that their cultures mesh. Business combinations, of course, involve people, and “soft” factors related to culture need to be addressed with care. Important as these factors are, however, they do not predict success. Excellent combinations have been struck across wide cultural differences, and harmonious personal relationships have often failed to support poorly designed business combinations. I have observed that when “cultural differences” are cited to explain the failure of a deal, the phrase more often than not hides conflicting interests and incompatible strategies.

Alternatively, the effective-governance law might seem to depend mostly on the legal structure of a combination. After all, that structure will reflect some high-level decisions, such as whether to acquire part or all of a firm, how to share investments, and so on. But this too is only a partial condition of success. Joint value does not appear automatically when assets are combined; value creation and distribution also depend on how the combination is shaped and managed after the initial deal is concluded.

When the deal is an acquisition, for example, the acquired resources can be merged into existing units or not, and the man­agement personnel and processes may be left in place or replaced by that of the acquiring firm. Alliances, by definition, leave the partners to be managed as separate firms, but there may be varying degrees of cross-holdings or shared ownership. Simpler trans­actions usually include little joint management, just an agreement to exchange value on prearranged terms.

Across all these various forms, the elements that are critical to creating joint value must be managed effectively in a coordinated fashion. If the main source of joint value is economies of scale in production, for example, then the combination—whatever its form—must successfully integrate investment and management of the production facilities. If the joint value comes from sales, then that aspect of the deal, similarly, needs coordinated management. Often, the elements critical to a combination do not reside in every part of the value chain. Thus, many combinations can have successful outcomes even if they fall short of full integration and focus only on collaboration in selective areas. But in such combinations, too, excessive rivalry, conflict, or differences in management approach can doom the effort.

Third Law: Share the Value Created

Even when joint value is created by a well-governed combination, your company might not receive enough of the value. That’s why the last law is certainly not the least: ultimately, the joint gains need to be divided in a way that leaves each party better off than it would have been without the combination. The share of profits is the reward, or incentive, that encourages each party to contribute its resources to the combination.

To continue the metaphor, the 3 in the 1 + 1 = 3 of the first law needs to be divvied up. The shares are not always predetermined and don’t need to be equal. So, perhaps the summary formula will look like 1 + 1 = 1.4 + 1.6. The split can also be 50-50 or 80-20 or anything else. What matters is that each party earns a fraction high enough to convince it to redirect its assets and efforts from another use into the combination.

Determining this split of profits is often just as hard as estimating the joint value itself. Just as the joint value depends on future trends in the competitive environment, so too does the division of profits. The balance of power between the parties in the combina­tion usually evolves, and with it, so do the profit shares. For example, a partner may go into an alliance with weakness at the bargaining table, but may gain strength over time—perhaps because its own business options are growing and its contributions to the alliance have become more valuable. As a result, whatever division of gains was agreed upon at the start may come under strain over time, with one party pushing for a renegotiation or angling for new ways to capture additional value. The survival of the alliance may then be at risk if the new conditions are not accommodated.

Changes in the division of gains over time are also common in acquisitions, though in these deals the changes express them­selves differently. In a cash acquisition (or divestment), one party is paid its share and the other gets the remaining returns, including both upside and downside potentials. If the former owners of the acquired resources retain some ownership in the new combination, perhaps because the acquisition is financed by stock, then they share somewhat in the subsequent risk of the combination. In that case, over time, each party may realize more (or less) value than what was initially anticipated.

The three laws of the remix strategy apply to all industries and types of combinations — from mergers in industrial sectors to software partnerships in the emerging Internet of Things. To see how the laws work in practice — and what happens when combinations fail to fulfill them — consider the combination strategies of Daimler and of Renault in the early 2000s. It’s a well-known story, but we will use a new lens to compare and dissect these deals.

Leaders at Daimler and at Renault faced similar strategic issues. Each company’s leadership team decided that it needed to expand its footprint globally and increase its volume of production. Organic growth seemed a slow and difficult way to achieve these goals. Both Daimler and Renault therefore sought combinations with existing companies that could help them expand production and sales globally. In other words, both companies saw a potential to create joint value through a business combination—the first law of every business combination. From there, however, they took different steps, which have led to widely different results.

Daimler proceeded by acquiring Chrysler in the United States and then buying a one-third stake in Mitsubishi in Japan. Later, it also took a minority stake in Hyundai Motors in Korea, formed a three-way auto-engine joint venture with Hyundai and Mitsubishi, and added joint ventures in China. Overall, Daimler created a complex network of alliances worldwide at the same time that it worked to integrate the whole of Chrysler’s business.

Renault chose a different route for the governance of its combinations. It focused mostly on its relationship with Nissan, which was a substantially bigger player in Japan and worldwide than Mitsubishi. Renault acquired a one-third stake in Nissan. Later, the two companies created a 50-50 joint venture to run joint operations, and they invested directly in each other. The result was a more coordinated and balanced approach than Daimler’s multiple, but relatively separate alliances.

The differing governance choices made by each leadership team were heavily influenced by the conditions of its combination partners. Daimler was a more powerful player than any of its partners. Renault was almost equally balanced with Nissan in terms of production volumes. Nissan was financially in distress, but it had a proud and successful history, good technology, and good brands.

With these governance choices, collaboration between Renault and its partner was much more successful than that between Daimler and its partners. Daimler’s relationship with Mitsubishi unraveled after a few years; the German company later divested its ownership of Chrysler after pouring money into the American carmaker, at a deep loss on the investment. Renault, by contrast, suc­cessfully turned Nissan around and created an integrated global operation rooted in Europe and Japan. The second law of business combinations helps explain Daimler’s failure and Renault’s success.

The third law of the remix strategy came into play too. Because the structures of the deals were different, value was shared differently in the two cases. To acquire Chrysler, Daimler paid off Chrysler shareholders with a one-third premium over market value; in other words, the returns to those former owners of the resource were fixed at this point. The residual returns to whatever joint value DaimlerChrysler might create would accrue to the shareholders of the combined company. Unfortunately, because the actual joint value created was nega­tive, these shareholders were left with negative returns.

The Renault-Nissan partnership, by contrast, set out to create new value for all parties and to pay out benefits as the new value occurred. As a result, the structure of the alliance enabled both parties to gain (or lose, if that were the case) proportionally over time. Their mutual and partial shareholdings were the primary way in which they shared the returns of their cooperation.

Renault was clearly more successful with its combination strategy than Daimler. And the benefits of its alliance with Nissan still resonate today, as the partners continue to manage their global businesses together. Even Daimler has since invested in that combination, buying minority shares in Renault and Nissan.

The remix strategy is more relevant today than ever. Not only is the pace of mergers and acquisitions at an all-time high, but alliances, partnerships, and multiparty consortia are increasingly popular, even if sometimes below the radar. Many big pharma companies rely on partnerships for half or more of their drug pipeline. Business models using sharing and technology platforms depend on remixes too. And incumbent firms in traditional industries have to learn to evolve and adapt — often by bringing in assets from outside their boundaries. Increasingly, competition is a battle among groups of allied firms, not between stand-alone companies. Understanding and applying the three laws are keys to success in this new world.

This was adapted from The Remix Strategy: The Three Laws of Business Combination.

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