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Organizational Emergence and Firm Formation
Organizational Emergence and Firm Formation Elizabeth Garnsey, Institute for Manufacturing, University of Cambridge, Cambridge, UK Sarah Lubik, Simon Fraser University, BC, Canada Paul Heffernan, Institute for Manufacturing, University of Cambridge, Cambridge, UK Ó 2015 Elsevier Ltd. All rights reserved.
Abstract This article presents the emergence and evolution of an organization as a response to the demands faced by the newly created firm, shaped by a process of problem solving in response to change emerging both from the environment and from the firm itself. Successful firms are those that successfully adapt as demands evolve, in this case, specifically with respect to their organization. Such adaptation requires flexibility and diversity within the firm, attributes that must be shaped by the firm’s managers.
Introduction
New Firm Formation and Value Creation
The main focus of this article is the creation and development of organization within new and young firms. In this article, organizations are viewed as more or less enduring groups of people in a collective with a common identity, engaged in some common activity that is structured through a division of labor (differentiation) and distribution of authority. Selfsustaining organizations can be viewed as input–output systems, obtaining resources from their ecosystem and transforming them into outputs that bring in the returns that sustain the organization. A commercial organization must appropriate and retain some of the value it generates through market transactions (revenue) if it is to continue (Davis, 1973; Casson, 1982). Not-for-profit organizations that rely on donors or public revenues also must generate value of some kind if external resource providers are to continue supporting them. Private sector firms, the basic units of a market economy (Edquist, 2005), are the focus of this article, with special reference to new firms, which widely are acknowledged to contribute to economic growth and industrial revitalization. Despite increasing media and academic attention to organizations that are new entrants to industries, there are still many gaps in our understanding of how new organizations emerge and develop. This can be attributed in part to the fragmented analysis to which this topic has been subjected and partly to misapprehensions as to what can be explained. Penrose (1959) showed that the specific determinants and behavior of a particular unit, such as a firm, is inherently unpredictable, but nevertheless, we can aim to gain a better understanding of processes of development. Building on the work of Penrose (1995), we focus on the processes of change in new firms (Garnsey, 1998; Brush et al., 2001). Applying the ideas of Penrose to the development of new firms shows how emergence is driven by both internal and external dynamics. We first look at new firm formation and value creation, from the perspective of firm growth and organizational evolution. We then examine firm fitness in relation to its business environment, considering both the firm’s ability to influence its environment and the firm’s evolution to fit its ecosystem. We then discuss dominant approaches to the study of new firm formation. We conclude with recommendations for further study and policy.
For a firm to survive in a market economy, opportunities must be detected and input resources obtained to produce offerings that can be exchanged for income over and above the cost of production (Druilhe and Garnsey, 2006). Thus, the firm must create value for customers equal or superior to market alternatives and capture enough value to keep the firm in business, Opportunity recognition, the building of a productive base and creating and sustaining returns, will be discussed in the following sections along with the organizational evolution that follows each step.
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Opportunity Recognition Perception of an opportunity to create value, either one that currently exists or could be created, is often what triggers the process of new firm formation by the founder or entrepreneur (Penrose, 1959). Firms are sometimes founded, however, before the business idea has fully taken form, as might be the case if a firm is founded to exploit a new technology without a clear choice of application. The availability of a new resource may raise awareness of an opportunity; for example, advances in genetics drew the attention of microbiologists to new opportunities in pharmaceuticals. The perception of a new market need may trigger awareness of an opportunity; for example, the need for reliable energy in developing countries is increasingly inspiring technologists and entre-preneurs to find low-cost energy solutions. Once organi-zations start to develop, that opportunity detection process is unlikely to be the preserve of a single individual, and the extent to which the firm is able to develop effective learning processes becomes important (Lumpkin and Lichenstein, 2005).
Early Organizational Development The early development of the firm involves both maturation and growth. Development refers to a process of maturation involving changes in structure and activity, while growth in a firm refers to an expansion in size or other indicators. Emergence of the firm may be preceded by a period of preparation; as opportunity scanning, consultation, and discussion often take place before start-up, the date marking the formal
International Encyclopedia of the Social & Behavioral Sciences, 2nd edition, Volume 17
http://dx.doi.org/10.1016/B978-0-08-097086-8.73099-6
Organizational Emergence and Firm Formation founding of the firm is to some extent arbitrary. If this process takes place, the maturity and market readiness of the business concept on start-up is variable. Serial entrepreneurs or those spinning their firm out of an existing organization (such as a large firm or university lab) may have developed and even tried out a business concept in a previous organization; alternatively the initiative may be pioneering. Some firms are started by first-time entrepreneurs or with technology still in need of further development; for example science-based university spinouts. Such firms may grow significantly in terms of resource endowment and employees while still being far from market, as occurs in the case of science-based firms in which the technology has a long gestation period, as in biopharm and new materials. The development of the firm from original concept to operational entity involves cumulative problem solving; the original ideas for the business are modified frequently, either because of resource availability or because the entrepreneurs’ assessment of the opportunity shifts. In contrast to this experimental mode, the corporate strategic planning that occurs in established firms assumes much greater consistency of direction as required for hierarchical control and accountability. Preliminary scanning for business opportunities gives way to management tasks as the new firm matures. But this does not imply that problems are solved once and for all as ‘stages of growth’ perspectives imply. Entrepreneurs frequently revert to opportunity scanning when their goals come into question or if they start another line of business. Scanning opportunities for new product introduction is a continuous process when product life cycles are short. The opportunities open to the new firm and how fast it is able to grow initially depends on resource endowments the founders bring to the start-up. When founders bring unequal contributions to the ventures’ initial resource endowment, this should be reflected in the founders’ agreement that records the new firm’s ownership structure at the time of incorporation. Among the benefits of founding a company is that company law can be used to define ownership and avoid some of the complications of multiple ownership. For example, lack of clarity over intellectual property (IP) and other ownership issues can result in conflict later on. Limited liability and company law offer further benefits to a firm registered as a company, beyond those available to an unincorporated form of organization. Since it takes time to produce outputs that generate revenues, a critical initial issue is how to cover the costs of start-up. For entrepreneurs, convincing funders of the prospects for their venture is the key to openings beyond their own immediate means. They are more likely to attract investors on terms acceptable to them if they can develop and add value to their own resources. A working prototype is more valuable than a design and a customer base makes a firm more valuable still. The ability to attract finance depends on the entrepreneur’s ability to ‘create confidence’ in investors (Penrose, 1995: p. 38). If confidence is lost, investors can withdraw support or exert other sanctions. Investors with a large stake in a venture sit on the new firm’s board of directors. An entrepreneurial chief executive can be replaced by a dissatisfied board. Entrepreneurs who want to retain autonomy may choose to make do without recourse to external investment,
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at the risk of having too few resources to realize extensive opportunities.
Building a Productive Base A key challenge is to build a productive base from which to pursue opportunities (Garnsey et al., 2006). This productive base is made up of all resources, including human, financial, physical, technological, and organizational resources, that are required to seize the identified opportunity (Clarysee et al., 2005). With regard to human capital, entrepreneurs have to find partners, assistants, champions, and other potential resource providers and convince them that they too can benefit from the proposed business experiment (Lubik et al., 2011). Many studies show that prospects are better for ventures founded by a team of entrepreneurs (Storey, 1994; Reynolds and White, 1997). Depending on the sector and business model of the firm, more or less financial capital must be raised. Physical and technological resources can be accessed through a number of often-creative arrangements (Garnsey et al., 2007). The resources required will differ according to the activity undertaken; for example, firms that chose to manufacture a complete product are likely to require a much larger resource base, in terms of financial and physical resources, than a firm competing in the market for technology (licensing). The revenue-generating activities a firm plans to undertake, such as licensing, service, manufacturing, or franchising, have implications for both requisite investment and competition. The production of new IP (as opposed to IP inherited or bought from the new firm’s initial endowment) requires a distinctive base for productive activity, as does software production (Arora et al., 2001). Scientific research often requires a laboratory base in a research environment, which is very costly to duplicate in a new firm. For this reason, young technology firms are likely to engage in partnership arrangements. But entrepreneurs’ specialist skills can constitute a large part of the productive base if they use their knowledge base for consulting, which allows them to continue the development of their core technology while generating early revenue streams. At the other extreme, if the productive base is highly capital intensive (i.e., requires significant external finance and investment in physical assets), this constitutes a barrier to entry for most entrepreneurs. Activities that have low barriers to entry, such as catering, are inevitably subject to greater competition. To address common problems, some start-ups replicate management procedures used elsewhere. For example, franchising arrangements provide detailed specifications for operational procedures. Franchising arrangements guide the creation of a productive base in a new unit and accelerate start-up through imitation, but they prevent further innovation. Because many organizations are concerned with using knowledge to solve problems for producers and users, a productive base that relies more on knowledge rather than physical output is increasingly common and distinctive (Teece, 1998). Knowledge cannot remain exclusive once it has been shared, and hence there is a need to find ways to create IP that can be protected from competition and bring in license fees and royalties through patents and copyright. It is
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unusual for licensing revenues to be sufficient to sustain a company, except with valuable new medical entities or well-protected generic technologies. Protection usually is afforded by extensive patenting portfolios, but patents are difficult for a new firm to defend. Corporate partners licensing the technology from a new firm will have an interest in protecting its IP (to prevent competitors from obtaining it illegally), deterring potential patent infringers, as was the case for the chip design company ARM.
Organizing Productive Activity In a firm that is set up anew, with no precedents to follow, the firm’s productive activity involves a division of labor and methods of coordination that start out fluid and experimental (Utterback, 1994). As experience is accumulated, a problemsolving repertoire develops and ways of carrying out tasks and requirements are embodied in procedure (Lumpkin and Lichenstein, 2005). Roles are assigned and rules are adopted to save time and improve coordination (Mintzberg, 1979: p. 2). By drawing on previous learning, the emergence of routines can improve the organization of production and revenue generation. Over time, routines affect outlook as well as procedure. Solutions that have been found to work come to be taken for granted and part of the unconscious assumptions of the organization. Tacit knowledge is conveyed to new members as the way to do things. Underlying assumptions about how things should be done make up the emerging culture of the firm, which is influenced by the outlook and preconceptions of the founding entrepreneurs. At first, tasks are shared but as soon as a division of labor sets in, specialist functions emerge: finance, production, sales, marketing, and human resources. In this way, the firm begins to develop competence, which is the product of problem-solving activities. Competences enable the firm to respond to changing opportunities and threats. The new firm develops problemsolving skills and embeds these in procedures and routines. Routines can be viewed as “patterns of interactions that represent successful solutions to particular problems” (Teece et al., 1997) and become regular features of the organization’s way of doing things. As the firm grows more complex, standardization of procedures is needed so that decision making can deal mainly with exceptions and the need for supervision can be reduced (Cyert and March, 1963). Official standard procedures are available for purchase and can help firms learn from practices used elsewhere.
Creating and Sustaining Returns Problems of coordination and direction become more acute as the firm grows more complex and may require skills beyond those of the founders. Thus, the rate of return can be improved by speeding up throughput in more rapid production cycles, resulting in shorter lead times from input to invoice. But even if professional managers improve efficiency, further expansion is by no means ensured. The original offering of a service, product, or product range will have to be updated or extended. Many firms are unable to generate or mobilize sufficient additional resources to support the growth they need to make them less vulnerable (Garnsey and Heffernan, 2005). Sales growth is
needed to achieve the minimum efficient scale (MES) of operations in an activity or in cases in which only a higher level of market share can secure the firm against competition. To achieve MES, the firm requires additional resources and must retain talent through opportunities for promotion. This requires development capital, which is never easy to obtain from external sources. Retained earnings provide the most autonomous source of investment capital but are unlikely to be sufficient for new companies with few reserves. Servicing the interest charges on bank loans raises costs. These challenges make it difficult for young firms to show an increase in profits even where their output and revenues are increasing. Whether or not a primary aim of the entrepreneurs is profit, opportunity realization depends on returns that cover costs and provide reserves to see the firm through contingencies that endanger cash flow. The need to be profitable was brought home after the dot.com crash during which investors lost patience with ventures burning through initial investment without advancing toward profitability. Failure to show profits can result in a vicious cycle of investor and customer withdrawal, outcomes that distorted accounting practices attempt to conceal but instead may precipitate. Not all new firms achieve the competitive advantage or secure a rent-generating position that enables them to accumulate resources in a growing product and asset base (Tidd et al., 1998). The advantage of the minority who do so is reinforced through reinvestment of retained earnings. New opportunities may be identified – positively affected by the increased knowledge base of the firm. This resource accumulation process provides necessary reserves for dealing with the potential resource shortfalls (Cyert and March, 1963). Organizational slack, the amount of resources the firm has in excess of the minimum required to remain operational, provides a buffer against external shocks and offers the means to explore new opportunities without endangering the current resource-generation process. The firm itself becomes a useful asset once it has a market value as an entity (Lubik et al., 2012). If the firm initially was funded with venture capital (this applies to only a small minority of start-ups), their investors may insist on an early exit route. Realizing the value embodied in the firm is a challenge, as the value is only made manifest when on exit (via a buy out, a takeover, or bankruptcy) or if the firm launches on the stock market in an initial public offering. The advantage of going public is that the firms’ shares become a liquid asset that can be bought and sold on the market. In return for funding, however, the founder managers may have to cede control of the firm to a board of directors that includes external investors. For the founders and managers of some young firms it is a problem, indeed a dilemma, that resources for growth come at the cost of loss of autonomy.
The Firm in Its Selection Environment – the Issue of Fitness The firm is not passive in relation to its environment as the founding entrepreneurs choose their business environment in selecting their business opportunity (Penrose, 1959). Evolutionary theory represents the firm’s environment as the arena in which selection forces are exerted; these reflect the fitness criteria that are required of firms in that environment
Organizational Emergence and Firm Formation
(Nelson and Winter, 1982). Selection processes are experienced as the firm interacts with resource providers (including investors, the knowledge environment, and labor sources), coproducers, customers, and competitors and regulators. If they cannot find others prepared to do business with them, they are eliminated from that environment. There is scope for agency by the entrepreneurial firm, however, which can be proactive in a number of ways, including selecting a business mode and choosing activities and business partners best suited to a particular environment. For example, a venture producing solar cells may become involved in lobbying and standards setting, thus influencing the selection criteria in its environment. The following section examines the firm’s coevolution with its environment as its ecosystem and business evolves.
Ecosystem Evolution The firm’s environment is likely to be dynamic; with continual changes taking place in the firm’s input markets and its output markets. Important aspects of input markets include the allocation of resources by resource providers, and the prospects for coproduction with other organizations or of outsourcing. The growth and decline of product markets, and the changing level of competition, affect opportunities and firms’ prospects (Utterback, 1994). Important features of the new firm’s environment include the operations of the capital market that affect conditions of exit, merger, and acquisition. A key question in this respect is how firms coevolve with others in the markets and networks in which they operate, and this depends on how the firm is organized to create and capture value in its business environment. For example, in the early days of the fuel cell market, new ventures often were forced to develop the full spectrum of innovations and complements required for application, from fuel cell-specific components to hydrogen generators. As the industry matured and more companies entered the market, however, some firms began to specialize in hydrogen production, others in fuel cells for specific applications, and others in distribution.
Organizational Evolution The business model provides a concept that bridges the internal organization of the firm and the way the firm organizes relations and transactions with external players in its business environment (Amit and Zott, 2010), which also can be viewed as a business ecosystem (Adner and Kapoor, 2010). As the organization emerges, it relies on an implicit or explicit business model to enable it to create value. The extent to which a firm can implement the business model depends also on what Teece (2007) has described as the ‘microfoundations’ of enterprise performance “. the distinct skills, processes, procedures, organizational structures, decision rules, and disciplines .” (p. 1319). The firm’s business model represents the way the firm is organized to create and capture value (Teece, 2010) and specifies the firm’s role in the wider value chain or web. In developing a business model, decision makers are ‘modeling’
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the conditions in which the firm will operate, its competitors, and it complementors in the innovation ecosystem, and on this basis, they are deciding how to create and capture value. A business model that allows the firm to create and capture value is a good fit with its firm’s ecosystem. Dynamic value creation and capture in a firm is developmental and occurs through economies of scope, resource building, and harnessing complementarities through benefits from partnerships. These are anticipated in a predictive business plan and are operationalized in the business model, which may be deliberate or emergent. In young firms operating under high uncertainty, business models are likely to evolve in unanticipated ways. Similar business models reflect similar responses to the business environment. For example, many ventures in biotech conduct early research and testing with close ties to university research, leaving marketing and distribution to the incumbent pharmaceutical firms that are likely to acquire them if their new medical entities are successful in clinical trials. The selection environment may select differentially for value creation and value capture over the course of business cycles. For example, there was plentiful seed capital and venture capital for start-ups that were far from realizing profit during the Internet boom, but resources were withdrawn when the dot.com ventures failed to create and capture value by producing products and services and reaching profitability. Surviving Internet firms learned from these selection force effects. The business models of successful firms provide proxy evidence of selection requirements in that environment. If the firm is to succeed, its business model must meet the fitness requirements of the business environment. If a market economy is to succeed, market forces must exert selection criteria that favor organizations creating value for users and investors – not only over the short term but also over the longer term. If selection forces exerted by the financial system favor short-term value capture over value creation, this erodes the ability of emerging firms to create wealth in the longer term.
Alternative Perspectives on Early Firm Growth There are two dominant approaches for looking at the emergence of new firms: the stages of growth process and the developmental process approach. These two approaches (e.g., Greiner, 1972; Kazamjian, 1988) both focus on dominant problems in the life of new firms. When considering stages of growth, Kazamjian (1988) distinguished six categories of dominant problems to growth in technology-based new ventures: those related to organizational systems, sales and marketing, people, production, strategic positioning, and external relations. When critical problems are solved successfully, the firm is able to continue to grow. This type of study focuses on taxonomies of problems in distinctive stages and assumes that firms progress sequentially across a specific sequence of stages. In contrast, the developmental approach focuses on processes of change and feedback effects that influence those changes. If similar developmental problems are addressed in sequence through similar phases of activity, regularities will be
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observed, but firms operating a different business model or engaged in different modes of activity will evolve differently (Garnsey, 1998). Regularities can be observed in companies producing similar products on the basis of similar business models (e.g., in early US computer hardware ventures). But the building of different kinds of resource base involves different sequences of activity – for example, developmental sequences in a research consultancy differ from those in a company producing medical instruments in house. Moreover, ventures may or may not inherit a resource base from another organization through demerger or spinout, and this will affect the sequence of activity required. On the basis of these considerations, we subscribe to a developmental approach, holding that there are no invariant phases of activity for all new firms as they emerge; instead, there are common requirements for development into an economically viable unit, but this can be achieved in a variety of ways. Just as there are common developmental processes at work as firms solve common problems, there are shared constraints to growth. Metcalfe (1998: p. 45) identified five specific kinds of limitation to growth. Limitations can be “in relation to the ability to purchase inputs and sell output as determined by the growth of relevant market environments; in relation to the availability of internal and external finance to expand capacity; in relation to the managerial implications of growth for the ability to control costs; in relation to the growth of rival firms and thus the specific market of the firm; and in relation to the ability to imagine and articulate growth opportunities” (Penrose, 1959). According to Metcalfe (1998), all of these elements come together to determine the economic fitness of the firm.
Conclusion This article has discussed how new firms move from recognizing or creating a business opportunity to becoming a viable market actor, and it considered how they evolve as organizations. This leads us to consider avenues for further study and practical policy recommendations. Economists examine the growth performance of new firms in the aggregate but do not enter the ‘black box’ of development processes within the firm. Entrepreneurship studies examine case histories, events, and situations, but they fail to set the firm in a wider context, which makes it possible to identify what features are specific to that case and what is an instance of more generic developments found in other cases. Strategy studies have only recently begun to address the issue of new firms and their growth; this issue increasingly is being addressed in terms of the business models of new organizations, the final topic of this article. Although the orthodox study of industry structure is relevant to understanding the business environment of new firms, the approach is too static to deal with the dynamic nature of the environment facing many new entrant organizations. The study of how organizations emerge shows the need for enterprises to adopt a dynamic approach to strategy (and the business models that operationalize strategy) in new organizations. Policy interventions should consider the coevolution of the firm and its environment. Policy makers who aim to promote
thriving new firms should ensure that markets and regulators are applying selection criteria that promote sustainable value creation by new firms. These include the availability of finance to cover the costs of start-up and early development before the firm can create value. Beyond competitive selection forces, partnerships are needed to enable newcomers to do business with established players in clusters and strategic alliances that promote open innovation. In the absence of such conditions, firms are unlikely to develop sustainable business models or to grow to a size at which a significant number of new jobs can be created.
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Abstract This article presents the emergence and evolution of an organization as a response to the demands faced by the newly created firm, shaped by a process of problem solving in response to change emerging both from the environment and from the firm itself. Successful firms are those that successfully adapt as demands evolve, in this case, specifically with respect to their organization. Such adaptation requires flexibility and diversity within the firm, attributes that must be shaped by the firm’s managers.
Introduction
New Firm Formation and Value Creation
The main focus of this article is the creation and development of organization within new and young firms. In this article, organizations are viewed as more or less enduring groups of people in a collective with a common identity, engaged in some common activity that is structured through a division of labor (differentiation) and distribution of authority. Selfsustaining organizations can be viewed as input–output systems, obtaining resources from their ecosystem and transforming them into outputs that bring in the returns that sustain the organization. A commercial organization must appropriate and retain some of the value it generates through market transactions (revenue) if it is to continue (Davis, 1973; Casson, 1982). Not-for-profit organizations that rely on donors or public revenues also must generate value of some kind if external resource providers are to continue supporting them. Private sector firms, the basic units of a market economy (Edquist, 2005), are the focus of this article, with special reference to new firms, which widely are acknowledged to contribute to economic growth and industrial revitalization. Despite increasing media and academic attention to organizations that are new entrants to industries, there are still many gaps in our understanding of how new organizations emerge and develop. This can be attributed in part to the fragmented analysis to which this topic has been subjected and partly to misapprehensions as to what can be explained. Penrose (1959) showed that the specific determinants and behavior of a particular unit, such as a firm, is inherently unpredictable, but nevertheless, we can aim to gain a better understanding of processes of development. Building on the work of Penrose (1995), we focus on the processes of change in new firms (Garnsey, 1998; Brush et al., 2001). Applying the ideas of Penrose to the development of new firms shows how emergence is driven by both internal and external dynamics. We first look at new firm formation and value creation, from the perspective of firm growth and organizational evolution. We then examine firm fitness in relation to its business environment, considering both the firm’s ability to influence its environment and the firm’s evolution to fit its ecosystem. We then discuss dominant approaches to the study of new firm formation. We conclude with recommendations for further study and policy.
For a firm to survive in a market economy, opportunities must be detected and input resources obtained to produce offerings that can be exchanged for income over and above the cost of production (Druilhe and Garnsey, 2006). Thus, the firm must create value for customers equal or superior to market alternatives and capture enough value to keep the firm in business, Opportunity recognition, the building of a productive base and creating and sustaining returns, will be discussed in the following sections along with the organizational evolution that follows each step.
364
Opportunity Recognition Perception of an opportunity to create value, either one that currently exists or could be created, is often what triggers the process of new firm formation by the founder or entrepreneur (Penrose, 1959). Firms are sometimes founded, however, before the business idea has fully taken form, as might be the case if a firm is founded to exploit a new technology without a clear choice of application. The availability of a new resource may raise awareness of an opportunity; for example, advances in genetics drew the attention of microbiologists to new opportunities in pharmaceuticals. The perception of a new market need may trigger awareness of an opportunity; for example, the need for reliable energy in developing countries is increasingly inspiring technologists and entre-preneurs to find low-cost energy solutions. Once organi-zations start to develop, that opportunity detection process is unlikely to be the preserve of a single individual, and the extent to which the firm is able to develop effective learning processes becomes important (Lumpkin and Lichenstein, 2005).
Early Organizational Development The early development of the firm involves both maturation and growth. Development refers to a process of maturation involving changes in structure and activity, while growth in a firm refers to an expansion in size or other indicators. Emergence of the firm may be preceded by a period of preparation; as opportunity scanning, consultation, and discussion often take place before start-up, the date marking the formal
International Encyclopedia of the Social & Behavioral Sciences, 2nd edition, Volume 17
http://dx.doi.org/10.1016/B978-0-08-097086-8.73099-6
Organizational Emergence and Firm Formation founding of the firm is to some extent arbitrary. If this process takes place, the maturity and market readiness of the business concept on start-up is variable. Serial entrepreneurs or those spinning their firm out of an existing organization (such as a large firm or university lab) may have developed and even tried out a business concept in a previous organization; alternatively the initiative may be pioneering. Some firms are started by first-time entrepreneurs or with technology still in need of further development; for example science-based university spinouts. Such firms may grow significantly in terms of resource endowment and employees while still being far from market, as occurs in the case of science-based firms in which the technology has a long gestation period, as in biopharm and new materials. The development of the firm from original concept to operational entity involves cumulative problem solving; the original ideas for the business are modified frequently, either because of resource availability or because the entrepreneurs’ assessment of the opportunity shifts. In contrast to this experimental mode, the corporate strategic planning that occurs in established firms assumes much greater consistency of direction as required for hierarchical control and accountability. Preliminary scanning for business opportunities gives way to management tasks as the new firm matures. But this does not imply that problems are solved once and for all as ‘stages of growth’ perspectives imply. Entrepreneurs frequently revert to opportunity scanning when their goals come into question or if they start another line of business. Scanning opportunities for new product introduction is a continuous process when product life cycles are short. The opportunities open to the new firm and how fast it is able to grow initially depends on resource endowments the founders bring to the start-up. When founders bring unequal contributions to the ventures’ initial resource endowment, this should be reflected in the founders’ agreement that records the new firm’s ownership structure at the time of incorporation. Among the benefits of founding a company is that company law can be used to define ownership and avoid some of the complications of multiple ownership. For example, lack of clarity over intellectual property (IP) and other ownership issues can result in conflict later on. Limited liability and company law offer further benefits to a firm registered as a company, beyond those available to an unincorporated form of organization. Since it takes time to produce outputs that generate revenues, a critical initial issue is how to cover the costs of start-up. For entrepreneurs, convincing funders of the prospects for their venture is the key to openings beyond their own immediate means. They are more likely to attract investors on terms acceptable to them if they can develop and add value to their own resources. A working prototype is more valuable than a design and a customer base makes a firm more valuable still. The ability to attract finance depends on the entrepreneur’s ability to ‘create confidence’ in investors (Penrose, 1995: p. 38). If confidence is lost, investors can withdraw support or exert other sanctions. Investors with a large stake in a venture sit on the new firm’s board of directors. An entrepreneurial chief executive can be replaced by a dissatisfied board. Entrepreneurs who want to retain autonomy may choose to make do without recourse to external investment,
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at the risk of having too few resources to realize extensive opportunities.
Building a Productive Base A key challenge is to build a productive base from which to pursue opportunities (Garnsey et al., 2006). This productive base is made up of all resources, including human, financial, physical, technological, and organizational resources, that are required to seize the identified opportunity (Clarysee et al., 2005). With regard to human capital, entrepreneurs have to find partners, assistants, champions, and other potential resource providers and convince them that they too can benefit from the proposed business experiment (Lubik et al., 2011). Many studies show that prospects are better for ventures founded by a team of entrepreneurs (Storey, 1994; Reynolds and White, 1997). Depending on the sector and business model of the firm, more or less financial capital must be raised. Physical and technological resources can be accessed through a number of often-creative arrangements (Garnsey et al., 2007). The resources required will differ according to the activity undertaken; for example, firms that chose to manufacture a complete product are likely to require a much larger resource base, in terms of financial and physical resources, than a firm competing in the market for technology (licensing). The revenue-generating activities a firm plans to undertake, such as licensing, service, manufacturing, or franchising, have implications for both requisite investment and competition. The production of new IP (as opposed to IP inherited or bought from the new firm’s initial endowment) requires a distinctive base for productive activity, as does software production (Arora et al., 2001). Scientific research often requires a laboratory base in a research environment, which is very costly to duplicate in a new firm. For this reason, young technology firms are likely to engage in partnership arrangements. But entrepreneurs’ specialist skills can constitute a large part of the productive base if they use their knowledge base for consulting, which allows them to continue the development of their core technology while generating early revenue streams. At the other extreme, if the productive base is highly capital intensive (i.e., requires significant external finance and investment in physical assets), this constitutes a barrier to entry for most entrepreneurs. Activities that have low barriers to entry, such as catering, are inevitably subject to greater competition. To address common problems, some start-ups replicate management procedures used elsewhere. For example, franchising arrangements provide detailed specifications for operational procedures. Franchising arrangements guide the creation of a productive base in a new unit and accelerate start-up through imitation, but they prevent further innovation. Because many organizations are concerned with using knowledge to solve problems for producers and users, a productive base that relies more on knowledge rather than physical output is increasingly common and distinctive (Teece, 1998). Knowledge cannot remain exclusive once it has been shared, and hence there is a need to find ways to create IP that can be protected from competition and bring in license fees and royalties through patents and copyright. It is
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unusual for licensing revenues to be sufficient to sustain a company, except with valuable new medical entities or well-protected generic technologies. Protection usually is afforded by extensive patenting portfolios, but patents are difficult for a new firm to defend. Corporate partners licensing the technology from a new firm will have an interest in protecting its IP (to prevent competitors from obtaining it illegally), deterring potential patent infringers, as was the case for the chip design company ARM.
Organizing Productive Activity In a firm that is set up anew, with no precedents to follow, the firm’s productive activity involves a division of labor and methods of coordination that start out fluid and experimental (Utterback, 1994). As experience is accumulated, a problemsolving repertoire develops and ways of carrying out tasks and requirements are embodied in procedure (Lumpkin and Lichenstein, 2005). Roles are assigned and rules are adopted to save time and improve coordination (Mintzberg, 1979: p. 2). By drawing on previous learning, the emergence of routines can improve the organization of production and revenue generation. Over time, routines affect outlook as well as procedure. Solutions that have been found to work come to be taken for granted and part of the unconscious assumptions of the organization. Tacit knowledge is conveyed to new members as the way to do things. Underlying assumptions about how things should be done make up the emerging culture of the firm, which is influenced by the outlook and preconceptions of the founding entrepreneurs. At first, tasks are shared but as soon as a division of labor sets in, specialist functions emerge: finance, production, sales, marketing, and human resources. In this way, the firm begins to develop competence, which is the product of problem-solving activities. Competences enable the firm to respond to changing opportunities and threats. The new firm develops problemsolving skills and embeds these in procedures and routines. Routines can be viewed as “patterns of interactions that represent successful solutions to particular problems” (Teece et al., 1997) and become regular features of the organization’s way of doing things. As the firm grows more complex, standardization of procedures is needed so that decision making can deal mainly with exceptions and the need for supervision can be reduced (Cyert and March, 1963). Official standard procedures are available for purchase and can help firms learn from practices used elsewhere.
Creating and Sustaining Returns Problems of coordination and direction become more acute as the firm grows more complex and may require skills beyond those of the founders. Thus, the rate of return can be improved by speeding up throughput in more rapid production cycles, resulting in shorter lead times from input to invoice. But even if professional managers improve efficiency, further expansion is by no means ensured. The original offering of a service, product, or product range will have to be updated or extended. Many firms are unable to generate or mobilize sufficient additional resources to support the growth they need to make them less vulnerable (Garnsey and Heffernan, 2005). Sales growth is
needed to achieve the minimum efficient scale (MES) of operations in an activity or in cases in which only a higher level of market share can secure the firm against competition. To achieve MES, the firm requires additional resources and must retain talent through opportunities for promotion. This requires development capital, which is never easy to obtain from external sources. Retained earnings provide the most autonomous source of investment capital but are unlikely to be sufficient for new companies with few reserves. Servicing the interest charges on bank loans raises costs. These challenges make it difficult for young firms to show an increase in profits even where their output and revenues are increasing. Whether or not a primary aim of the entrepreneurs is profit, opportunity realization depends on returns that cover costs and provide reserves to see the firm through contingencies that endanger cash flow. The need to be profitable was brought home after the dot.com crash during which investors lost patience with ventures burning through initial investment without advancing toward profitability. Failure to show profits can result in a vicious cycle of investor and customer withdrawal, outcomes that distorted accounting practices attempt to conceal but instead may precipitate. Not all new firms achieve the competitive advantage or secure a rent-generating position that enables them to accumulate resources in a growing product and asset base (Tidd et al., 1998). The advantage of the minority who do so is reinforced through reinvestment of retained earnings. New opportunities may be identified – positively affected by the increased knowledge base of the firm. This resource accumulation process provides necessary reserves for dealing with the potential resource shortfalls (Cyert and March, 1963). Organizational slack, the amount of resources the firm has in excess of the minimum required to remain operational, provides a buffer against external shocks and offers the means to explore new opportunities without endangering the current resource-generation process. The firm itself becomes a useful asset once it has a market value as an entity (Lubik et al., 2012). If the firm initially was funded with venture capital (this applies to only a small minority of start-ups), their investors may insist on an early exit route. Realizing the value embodied in the firm is a challenge, as the value is only made manifest when on exit (via a buy out, a takeover, or bankruptcy) or if the firm launches on the stock market in an initial public offering. The advantage of going public is that the firms’ shares become a liquid asset that can be bought and sold on the market. In return for funding, however, the founder managers may have to cede control of the firm to a board of directors that includes external investors. For the founders and managers of some young firms it is a problem, indeed a dilemma, that resources for growth come at the cost of loss of autonomy.
The Firm in Its Selection Environment – the Issue of Fitness The firm is not passive in relation to its environment as the founding entrepreneurs choose their business environment in selecting their business opportunity (Penrose, 1959). Evolutionary theory represents the firm’s environment as the arena in which selection forces are exerted; these reflect the fitness criteria that are required of firms in that environment
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(Nelson and Winter, 1982). Selection processes are experienced as the firm interacts with resource providers (including investors, the knowledge environment, and labor sources), coproducers, customers, and competitors and regulators. If they cannot find others prepared to do business with them, they are eliminated from that environment. There is scope for agency by the entrepreneurial firm, however, which can be proactive in a number of ways, including selecting a business mode and choosing activities and business partners best suited to a particular environment. For example, a venture producing solar cells may become involved in lobbying and standards setting, thus influencing the selection criteria in its environment. The following section examines the firm’s coevolution with its environment as its ecosystem and business evolves.
Ecosystem Evolution The firm’s environment is likely to be dynamic; with continual changes taking place in the firm’s input markets and its output markets. Important aspects of input markets include the allocation of resources by resource providers, and the prospects for coproduction with other organizations or of outsourcing. The growth and decline of product markets, and the changing level of competition, affect opportunities and firms’ prospects (Utterback, 1994). Important features of the new firm’s environment include the operations of the capital market that affect conditions of exit, merger, and acquisition. A key question in this respect is how firms coevolve with others in the markets and networks in which they operate, and this depends on how the firm is organized to create and capture value in its business environment. For example, in the early days of the fuel cell market, new ventures often were forced to develop the full spectrum of innovations and complements required for application, from fuel cell-specific components to hydrogen generators. As the industry matured and more companies entered the market, however, some firms began to specialize in hydrogen production, others in fuel cells for specific applications, and others in distribution.
Organizational Evolution The business model provides a concept that bridges the internal organization of the firm and the way the firm organizes relations and transactions with external players in its business environment (Amit and Zott, 2010), which also can be viewed as a business ecosystem (Adner and Kapoor, 2010). As the organization emerges, it relies on an implicit or explicit business model to enable it to create value. The extent to which a firm can implement the business model depends also on what Teece (2007) has described as the ‘microfoundations’ of enterprise performance “. the distinct skills, processes, procedures, organizational structures, decision rules, and disciplines .” (p. 1319). The firm’s business model represents the way the firm is organized to create and capture value (Teece, 2010) and specifies the firm’s role in the wider value chain or web. In developing a business model, decision makers are ‘modeling’
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the conditions in which the firm will operate, its competitors, and it complementors in the innovation ecosystem, and on this basis, they are deciding how to create and capture value. A business model that allows the firm to create and capture value is a good fit with its firm’s ecosystem. Dynamic value creation and capture in a firm is developmental and occurs through economies of scope, resource building, and harnessing complementarities through benefits from partnerships. These are anticipated in a predictive business plan and are operationalized in the business model, which may be deliberate or emergent. In young firms operating under high uncertainty, business models are likely to evolve in unanticipated ways. Similar business models reflect similar responses to the business environment. For example, many ventures in biotech conduct early research and testing with close ties to university research, leaving marketing and distribution to the incumbent pharmaceutical firms that are likely to acquire them if their new medical entities are successful in clinical trials. The selection environment may select differentially for value creation and value capture over the course of business cycles. For example, there was plentiful seed capital and venture capital for start-ups that were far from realizing profit during the Internet boom, but resources were withdrawn when the dot.com ventures failed to create and capture value by producing products and services and reaching profitability. Surviving Internet firms learned from these selection force effects. The business models of successful firms provide proxy evidence of selection requirements in that environment. If the firm is to succeed, its business model must meet the fitness requirements of the business environment. If a market economy is to succeed, market forces must exert selection criteria that favor organizations creating value for users and investors – not only over the short term but also over the longer term. If selection forces exerted by the financial system favor short-term value capture over value creation, this erodes the ability of emerging firms to create wealth in the longer term.
Alternative Perspectives on Early Firm Growth There are two dominant approaches for looking at the emergence of new firms: the stages of growth process and the developmental process approach. These two approaches (e.g., Greiner, 1972; Kazamjian, 1988) both focus on dominant problems in the life of new firms. When considering stages of growth, Kazamjian (1988) distinguished six categories of dominant problems to growth in technology-based new ventures: those related to organizational systems, sales and marketing, people, production, strategic positioning, and external relations. When critical problems are solved successfully, the firm is able to continue to grow. This type of study focuses on taxonomies of problems in distinctive stages and assumes that firms progress sequentially across a specific sequence of stages. In contrast, the developmental approach focuses on processes of change and feedback effects that influence those changes. If similar developmental problems are addressed in sequence through similar phases of activity, regularities will be
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observed, but firms operating a different business model or engaged in different modes of activity will evolve differently (Garnsey, 1998). Regularities can be observed in companies producing similar products on the basis of similar business models (e.g., in early US computer hardware ventures). But the building of different kinds of resource base involves different sequences of activity – for example, developmental sequences in a research consultancy differ from those in a company producing medical instruments in house. Moreover, ventures may or may not inherit a resource base from another organization through demerger or spinout, and this will affect the sequence of activity required. On the basis of these considerations, we subscribe to a developmental approach, holding that there are no invariant phases of activity for all new firms as they emerge; instead, there are common requirements for development into an economically viable unit, but this can be achieved in a variety of ways. Just as there are common developmental processes at work as firms solve common problems, there are shared constraints to growth. Metcalfe (1998: p. 45) identified five specific kinds of limitation to growth. Limitations can be “in relation to the ability to purchase inputs and sell output as determined by the growth of relevant market environments; in relation to the availability of internal and external finance to expand capacity; in relation to the managerial implications of growth for the ability to control costs; in relation to the growth of rival firms and thus the specific market of the firm; and in relation to the ability to imagine and articulate growth opportunities” (Penrose, 1959). According to Metcalfe (1998), all of these elements come together to determine the economic fitness of the firm.
Conclusion This article has discussed how new firms move from recognizing or creating a business opportunity to becoming a viable market actor, and it considered how they evolve as organizations. This leads us to consider avenues for further study and practical policy recommendations. Economists examine the growth performance of new firms in the aggregate but do not enter the ‘black box’ of development processes within the firm. Entrepreneurship studies examine case histories, events, and situations, but they fail to set the firm in a wider context, which makes it possible to identify what features are specific to that case and what is an instance of more generic developments found in other cases. Strategy studies have only recently begun to address the issue of new firms and their growth; this issue increasingly is being addressed in terms of the business models of new organizations, the final topic of this article. Although the orthodox study of industry structure is relevant to understanding the business environment of new firms, the approach is too static to deal with the dynamic nature of the environment facing many new entrant organizations. The study of how organizations emerge shows the need for enterprises to adopt a dynamic approach to strategy (and the business models that operationalize strategy) in new organizations. Policy interventions should consider the coevolution of the firm and its environment. Policy makers who aim to promote
thriving new firms should ensure that markets and regulators are applying selection criteria that promote sustainable value creation by new firms. These include the availability of finance to cover the costs of start-up and early development before the firm can create value. Beyond competitive selection forces, partnerships are needed to enable newcomers to do business with established players in clusters and strategic alliances that promote open innovation. In the absence of such conditions, firms are unlikely to develop sustainable business models or to grow to a size at which a significant number of new jobs can be created.
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