BSL 1: Framework - University Of Illinois

Business Strategy for Lawyers Chapter 1: Framework Prof. Amitai Aviram [email protected] University of Illinois College of Law Copyright Amitai Aviram. All Rights Reserved S14D Framework Overview of Chapter 1 a) b) c) d) 2 Introduction to BSL What is business strategy? Business intelligence

The value pool Amitai Aviram. All rights reserved. Introduction to BSL What this course is/isnt about No law (!!!) Course is about how firms behave to maximize their profits Some such behavior can violate the law (e.g., antitrust) Course will give you a deeper understanding of how businesspeople think Your clients You (if youre a partner/solo practitioner) The businesses you oversee (if youre a regulator) But not a business school course either Business strategy for lawyers This course does not prepare you to be CEOs It prepares you to either be:

Regulators; or Lawyers representing corporate clients before regulators 3 Amitai Aviram. All rights reserved. Introduction to BSL What this course is/isnt about What does that mean? Consider both individual firm & market-wide impact CEO focuses only on own firm, subject to legal constraints Regulator interprets/enforces law, so subject to legal constraints would lead to circular thinking Emphasis on present analysis, not future predictions CEO sets firms course Regulator makes decisions based on existing market conditions (& defend in court if challenged, so solid evidence is required) 4

Amitai Aviram. All rights reserved. Introduction to BSL What this course is/isnt about This is not a course about picking good stocks Fundamental analysis of investments does require knowledge of business strategy, but it also requires assessing what is the firms value But the analysis we use can help strategize your career So what is the course about? (i.e. what is strategy?) Creating/maintaining a fit between the strategic environment & firms strategic traits (applying strengths to opportunities), in order to best achieve the firms goals More about this in the What is strategy? section (BSL 1c) 5 Amitai Aviram. All rights reserved. Introduction to BSL

The challenges of studying BSL Dealing with uncertainty Law classes tend to assume a lot of certainty about the analytic process (e.g., a given test determines if X is liable) But real life (including legal practice) is not nearly as certain e.g., no rules & no analytical process that ensures business success A good analytical process helps focus on the issues that are likely to be the more relevant to success & identify tradeoffs between those issues Collecting information (business intelligence) Law classes tend to provide you with the relevant information But in real life, unless you have the power to subpoena information, you need to think of creative proxies for the information you actually need In this course, creative ways to collect information are a big part of the grading of your market analysis & team activities 6 Amitai Aviram. All rights reserved. Introduction to BSL Grading

Market analysis report Expected length: 10 pages or more You pick the market you analyze Students often pick either a market they are customers of, had worked in, or plan to work in (e.g., bankruptcy practice in northwest Illinois) Grade adjustments For: Attendance & participation in class discussion Participation in & quality of team activities Up to 1 grade-point up, unlimited adjustment down However, an upwards or downwards adjustment of more than of a grade point (e.g., from B+ to A-) is rare 7 Amitai Aviram. All rights reserved. Introduction to BSL

Market analysis report Select your market ASAP, so you can think of each new class through the lens of your market And figure out what information youll need to get Key criteria: experience, interest & availability of information Quality criteria Analysis (thoughtful application of analytical tools studied in this course) Business intelligence (creative ways of collecting information) All sources of info must be clearly referenced Doesnt qualify for ULWR credit Due on April 26 (Friday of the last full week of classes) Submit the paper by e-mail, as MS-Word (.doc or .docx) file Last class of the course (Monday, April 29) is cancelled; make-up will be announced 8 Amitai Aviram. All rights reserved. Introduction to BSL

Getting more information Slides, course outline & syllabus are posted and regularly updated on my website http://www.law.illinois.edu/aviram/ Talking to me outside of class Please e-mail prior to meeting with me Suggest when you would like to meet (not limited to office hours) Describe what you want to talk about E-mail: [email protected] Room 326 9 Amitai Aviram. All rights reserved. Introduction to BSL Defining commonly-used terms

10 Product: a good or a service Market: set of products that are close substitutes for each other Firm: a business that is involved in creating, modifying or distributing products (regardless of its legal status) Rivals (of a given firm): Other firms that participate in the same market(s) i.e., other firms that sell products that are close substitutes to products of the given firm Producers (re a given firm): firm + its rivals Supplier (of a given firm): person selling raw materials to firm Customer (of a given firm): person buying product from firm Customer may consume product or use it as raw material in its business Consumer: a customer who buys a product for personal use, rather than as raw material to produce & sell something Amitai Aviram. All rights reserved. Framework Overview of Chapter 1 a)

b) c) d) 11 Introduction to BSL What is business strategy? Business intelligence The value pool Amitai Aviram. All rights reserved. What is business strategy? Strategy & goals Strategy is a planning process designed to achieve the firms goal(s) Since this is a business strategy course, I will assume that the firms goal is to maximize the firms sustainable profits But similar tools apply to other goals (e.g., for non-profits, states, individuals) Thats the goal of most business functions, not just strategy

Operations management Research & development Human resources What distinguishes strategy from other business functions? 12 Amitai Aviram. All rights reserved. What is business strategy? What distinguishes strategy? Strategy addresses two questions: Which markets should the firm participate in to advance its goals? I.e., which pies do you want to have slices in? How can the firm create a sustainable competitive position in a market in which it participates? I.e., how can your firm get a bigger slice in those pies? 13 Amitai Aviram. All rights reserved.

What is business strategy? Which markets? Abstract answer to the first question (which markets to participate in): markets with A large or growing value pool (the total amount of value created by the business activities) In a benign strategic environment Strategic environment: the set of economic constraints that determines how much of the value of a business activity is captured by market participants (firm & rivals) rather than other actors (customers & suppliers) Value pool The strategic environment Substitution Total value created by biz activity (from raw materials to finished product delivered to consumers) 14 Entry

Rivalry Allocates the value pool between markets Amitai Aviram. All rights reserved. Supply chain What is business strategy? How to gain a sustainable competitive position? Abstract answer to 2nd question (sustainable competitive position): creating/maintaining a position thats valuable, unique & sustainable, because of a fit between strategic environment & firms strategic traits The strategic environment (Identifying threats & opportunities) Firms strategic traits Strategic actions (firm-specific competences & rigidities) (Applying firms traits to improve the environment for firm)

Position (Valuable, unique & sustainable match between environment & traits) 15 Amitai Aviram. All rights reserved. What is business strategy? Competitive position & SWOT analysis SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) is a simple, all-purpose strategic tool Concept: match strategic environment to firms strategic traits Environment divided between good (opportunities) & bad (threats) Firms traits divided between good (strengths) & bad (weaknesses) But SWOT analysis is simplistic Makes a sharp good vs. bad distinction, when in reality many factors are somewhere in the middle

More detailed tools are available to analyze both environment & firm Environment: substitution, entry, rivalry, supply chain Firm: strategic competences, strategic rigidities 16 Amitai Aviram. All rights reserved. What is business strategy? Summary: what distinguishes strategy? Firms goals (maximize sustainable profits) Which markets should the firm participate in to advance its goals? How can the firm create a sustainable competitive position in a market in which it participates? Value pool Strategic environment (substitution, entry, rivalry, supply chain) Strategic environment (current & future) Strategic traits (firm-specific competences & rigidities) Strategic actions (differentiation, coordination, confrontation) The table above summarizes the questions strategy addresses and the tools it uses to address those questions

17 We study the value pool in Section 1d Strategic environment: Chapter 2 Strategic traits: Section 3a Strategic actions: the rest of Chapter 3 Amitai Aviram. All rights reserved. Framework Overview of Chapter 1 a) b) c) d) 18 Introduction to BSL

What is business strategy? Business intelligence The value pool Amitai Aviram. All rights reserved. Business intelligence Developing a research plan 19 A major element in the quality of your market analysis is your ability to acquire information for your analysis (the other major element is the analysis itself)

Doesnt mean you should pick a market that has a lot of media exposure, or thats publicly listed you can get all the info you need from observation, interviewing, and other research methods Process Background reading of secondary sources (media, analyst reports, public SEC filings, etc.) to get a feel for the industry Create a report outline (based on the outline we will discuss in Section 3e), fill in the info you have & note the info you lack For each item of info you lack, determine what the ideal info would be, then think of proxies from available sources that can substitute for the ideal info Analyze the reliability of info you collected (including direction of bias) Depending on reliability & importance of the info to your analysis, determine if you need to collect more info on the issue Amitai Aviram. All rights reserved. Business intelligence Research methods

20 Secondary research Data that has already been collected by someone else: public filings that firms make to the Securities & Exchange Commission or other regulators, analyst reports, books, newspaper articles and interviews, blogs & websites Advantage: somebody did the work for you Disadvantages: info you need may not be available; info may not be reliable (Primary) quantitative research Acquire numerical data & analyzing it using statistical/accounting techniques Acquire the data from secondary sources, via survey, experiment, or quantify data that is non-numerical (e.g., number of newspaper articles in which word X appears each year) Advantage: gives precise results

Disadvantages: requires statistical or accounting knowledge, need high quality quantitative data, results depend on soundness of models assumptions (Primary) qualitative research Methods that analyze data that you collect without quantifying it Amitai Aviram. All rights reserved. Business intelligence Research methods 21 Qualitative research techniques Observation (physical or online) Interviewing (face-to-face, e-mail, phone, etc.) Surveys (multiple choice, quantitative, or open-ended): allow getting input from many people, but requires knowing exactly what you want to ask (no ability to follow up), and is time-consuming to process open-ended answers

Focus groups (discussion among multiple participants, moderated by the researcher): useful for brainstorming creative ideas or to discuss products that the individuals have little experience with, and for products which are consumed collectively or in which the benefit is connected to interacting with others Amitai Aviram. All rights reserved. Business intelligence Team project: business intelligence In the first team project we will gather business intelligence about one issue that comes up early in a market analysis identifying the bases of competition The first steps in your market analysis reports are:

22 Determining your starting point product You must begin by defining a specific product as your starting point, because different products (even similar ones) may be impacted differently by market forces If you are analyzing a merger/JV: each common product + synergy with not-common products If you are analyzing a firm: each of its products If you are analyzing a market: most typical product in the market Finding the basis of competition I.e., what makes the product good/better? Amitai Aviram. All rights reserved. Business intelligence Team project: business intelligence To find the bases of competition, start with customer needs that the product satisfies Example: Product J.D. degree; customer needs: getting a job @ big corporate law firm; getting promoted in current job; making professional contacts; sense of accomplishment; intellectual challenge

For each need, identify customer benchmarks What do customers look at to see if product responds to their needs? Example: Product J.D. degree; Customer benchmarks: US news ranking; perhaps % of grads who have such jobs (but do customers actually get this data?); geographical location Benchmark doesnt have to correctly reflect need; just be perceived by potential customers as reflecting their needs 23 Amitai Aviram. All rights reserved. Business intelligence Team project: business intelligence Working in a team, please research what are the bases of competition for a (U.S.) JD or LLM degree Starting point product: Illinois JD or LLM degree Figure out both customer needs & customer benchmarks The methods you use to collect information are as important as your conclusions Write your findings in an e-mail to me

(1 e-mail per team) 24 Amitai Aviram. All rights reserved. Framework Overview of Chapter 1 a) b) c) d) 25 Introduction to BSL What is business strategy? Business intelligence The value pool Amitai Aviram. All rights reserved. Value pool Defining value

Value: benefit to the buyer of a product minus all costs of getting the product to the buyer Value vs. profit: a sellers share of the value it creates is its profit, but not all value is usually captured by the seller Value is shared between customers, sellers & firms in other links of the supply chain E.g., I value a gadget @$500; I buy it for $250; it costs $100 to produce 26 Value: $400; sellers profit: $150; buyer surplus: $250 Note that value changes from buyer to buyer; profit is constant as long as costs & price remain the same

Amitai Aviram. All rights reserved. Value pool Defining the value pool 27 Value pool: aggregate value that can be captured by market participants (firm, rivals or customers) Firms share of the value pool is its profits Customers share of the value pool is the consumer surplus Size of the value pool determined by:

Value margin (value cost) Volume of sales Expanding the value pool is important to a firms profitability, but is mostly outside this courses scope We will briefly discuss highlights; in the report, address only if you very knowledgeable about the market Amitai Aviram. All rights reserved. Value margin Value margin vs. profit margin Profit margin = (price cost)/price

28 Example: Producing 3 widgets costs $5/widget in variable costs + $3 in overhead costs. Widgets are sold for $8/each Total costs = $18 ($6/widget) Cost/widget would change if you produced more widgets Profit margin = (8-6)/8 = 2/8 = 25% Value margin = (average value cost)/average value E.g., if widgets are valued at $11, $10 & $9, then average value is $10, and value margin is: (10-6)/10 = 40% Profit margin can be increased by increasing the value margin, but it can also be increased by increasing the firms share of the existing value pool (i.e., by reducing competition) Amitai Aviram. All rights reserved. Value margin Increasing the value margin

29 Adding value Engineering: add features, improve product performance, etc. Marketing: change customer perceptions of products value Cutting cost Operations management: exploit economies of scale & scope, improve efficiency of the production processes Financial management: cashflow synergies, diversification, fin. engineering Value margin is also affected by spillover effects from other markets

in supply chain; e.g., Adding value: crude oil was originally refined into kerosene for lighting. Invention of the car added value (and volume) to crude oil, because it could be refined into gasoline Cutting cost: technological changes in mining that lower cost of iron ore can increase value margin for producing steel Amitai Aviram. All rights reserved. Value margin Cashflow synergies 30 Fast-growing businesses require large investments

Firm must first invest/take losses and only later recoup profits, so these businesses result in a negative cashflow E.g., eBooks, smart phones, internet search engines Why invest in a business with negative cashflow? Other markets have low growth prospects, but generate a stable stream of income E.g., many cable operators, newspapers, utility companies Financial costs can be reduced by matching activity in cash-using markets & cash-generating markets Why does this reduce financial costs? Cant the firm borrow cash or issue shares to raise cash rather than generate it? Amitai Aviram. All rights reserved. Value margin Cashflow synergies: BCG matrix 31 The BCG (Growth-Share) matrix is one tool

designed to manage market portfolios in way that evens out the cashflow Uses market growth as proxy for cash usage Uses market share as proxy for cash generation Amitai Aviram. All rights reserved. Value margin Cashflow synergies: cash cow 32 Cash cow: Mature market generating significant positive cashflow Fund the firms other activities Why not have only cash cows? Amitai Aviram. All rights reserved.

Value margin Cashflow synergies: star 33 Star: Promising market, firm is well positioned in it; currently has negative cashflow The future of the firm; funded by firms cash cows (or by external financing) Amitai Aviram. All rights reserved. Value margin Cashflow synergies: question mark Question mark: Promising market, but firm is poorly positioned; currently has negative cashflow Firm must decide: Either

34 Invest heavily in order to capture dominant position (turn into a star); or Get out of the market Amitai Aviram. All rights reserved. Value margin Cashflow synergies: dog 35 Dog: Mature market & firm is poorly positioned; cashflow (positive or negative) is not significant Get out of the market (sell or shut down) Amitai Aviram. All rights reserved. Value margin

Cashflow: changes over time A product shifts positions over its lifecycle Firm maintains lead Success Market Matures Firm invests Firm loses lead Failure 36 Amitai Aviram. All rights reserved. Firm loses lead or market declines

Value margin Diversification Diversification attempts to reduce the volatility of profits (bad years less bad; good years less good) How is this different from cashflow considerations? 37 Cashflow: match markets that need cash with markets that produce cash; use present profits to create future profits Diversification: match markets that do well in certain circumstances with markets that do well in opposite circumstances; use present profits to offset present losses Amitai Aviram. All rights reserved.

Value margin Diversification: some terminology The outcome of most investments is uncertain To evaluate investments, we estimate probabilities of outcomes E.g., 50% likelihood of a 6% return; 50% likelihood of -4% return If the estimate is correct, we no longer have uncertainty, but we still have risk What has risk but no uncertainty? Investments are evaluated on two dimensions: Return: The average expected profit from the investment In the example above: 1% Risk: The likely deviation from the average In the example above: 5% 38 Amitai Aviram. All rights reserved.

Value margin Diversification: understanding risk Consider 3 investments, all of which offer 10% return A U.S. Treasury Bond: 100% probability of a 10% return B Mature market 50%: earn a 0% return 50%: earn a 20% return C Emerging market 50%: -100% return (lose entire investment) 50%: 120% return Risk of each investment: A: No deviation from average Zero risk B: 10% deviation from average C: 110% deviation from average 11 times the risk of B 39 Amitai Aviram. All rights reserved. Value margin

Diversification: understanding risk Review: Investment A 50% chance: 1% return 50% chance: 3% return Average: 2% Deviation from Avg. 1% 50% chance: 3% return 50% chance: 13% return Average: 8% Deviation from Avg. 5% Investment B Which is the riskier investment? Then why do we want to avoid higher risk? 40 Amitai Aviram. All rights reserved.

Value margin Diversification: how does it work? Diversification reduces risk without reducing the return Reason: Regression to the mean Imagine you are flipping a coin 10 times, counting how often it falls on heads Now imagine you are flipping the coin 1,000 times Whats more likely: Coin fell on heads between 4 & 6 times out of 10 Coin fell on heads 400-600 times out of 1,000 41 Amitai Aviram. All rights reserved. Value margin Diversification: how does it work? Jane owns 10 shares of Acme. Having just heard that she needs to diversify, she buys another 990 Acme shares. Did she reduce her risk? 42

Amitai Aviram. All rights reserved. Value margin Diversification: correlation Additional bets diversify only to the extent that they are not correlated with the existing bets Correlation: The observation that when theres a change in A, theres a change in B 43 Amitai Aviram. All rights reserved. Value margin Diversification: full correlation Two Acme shares: whenever theres a change in the price of one share, theres an identical change in the other share correlation between the shares is 1 (fully correlated) Splitting your funds between these two investments does not diversify at all Acme share & Ajax share: Ajax owns 30% of Acmes shares, owns no other assets & has no other

business correlation is 1 Again, splitting funds between these two investments offers no diversification 44 Amitai Aviram. All rights reserved. Value margin Diversification: some/no correlation Microsoft share & a lottery ticket: MSs share price doesnt affect chance of winning lottery or vice versa, so correlation is 0 (not correlated) Splitting your funds between these two investments diversifies Bank of America share & Citibank share: Some factors affect both companies prices (e.g., interest rates); other factors are independent for each company. Correlation is, say, 0.6 (partially correlated) Splitting your funds between these two investments diversifies somewhat, but not as well as the previous example 45

Amitai Aviram. All rights reserved. Value margin Diversification: negative correlation Ford share & ExxonMobil share: Exxon rises & Ford drops when gas prices are high. Correlation is, say, -0.3 (negatively correlated) Splitting your funds between these two investments is called hedging (partial protection in case your bet is wrong) Buying a Ford share & Shorting a Ford share: Correlation is -1 (whenever one investment goes up, the other goes down by the same amount) The two investments cancel out each other (if equal amounts invested in each) 46 Amitai Aviram. All rights reserved. Value margin Diversification: theory to practice Firms diversify by operating in several markets that have a low correlation with each other: firms returns should be close to the

projected (i.e., average) returns Firms hedge by operating (or buying financial instruments) in markets that have negative correlation with each other This reduces profitability (gains in one market will be offset by losses in the other) as the cost of reducing/eliminating the impact of a risk Diversify, hedge, or neither? Hedge: risks with high uncertainty & high impact on the firm Diversify: risks with lower uncertainty & high impact on the firm Neither: risks with a low impact on the firm The agency problem with diversification Diversification comes at expense of other goals (e.g., markets w/highest profit, most synergies). Can someone else diversify instead of the firm? Does management gain something from diversifying? 47 Amitai Aviram. All rights reserved. Value pool Volume of sales

What affects volume of sales? Factors unique to the particular product Economic cycles effects on demand (income effects); e.g., Demand for high-end products may decline during recessions Demand for low-end products may increase as people trade down Demand for some products is resistant to income effects (people buy the same amount in good times & bad) 48 Dont confuse income effects with price effects tendency to buy more when price is low & less when price is high

Spillover effects from other links in the supply chain Product life cycle Amitai Aviram. All rights reserved. Value pool Sales volume & product life cycle Another predictable pattern in which demand changes over time relates to the natural life cycle of a product Often assessed on a market level (industry life cycle), but many markets have multiple products in different life cycle stages Product: Market: 49 Fragmentation Shakeout

Maturity Amitai Aviram. All rights reserved. Decline Value pool Product life cycle Introduction 50 Demand: small, uncertain Competition: limited (few rivals; little substitution) Firms emphasize innovation & product recognition Cashflow: high cash usage (question mark)

Invest in hope of growing volume Some life cycles add a design or embryonic stage before introduction (no sales & high investment in R&D) Amitai Aviram. All rights reserved. Value pool Product life cycle Growth 51

Demand: increases (from early adopters & wealthy to mass market) Declining costs: economies of scale & experience curve Declining marginal value as high-value customers are all tapped Pressure on distribution system Competition: some features/biz models become dominant Firms enter successful segments (increasing substitution & rivalry) & exit failed segments Firms emphasize distribution, differentiation Cashflow: very high cash usage (star) Invest to increase sales Some life cycles divide growth into early (before one model dominates) & late phases Amitai Aviram. All rights reserved. Value pool Product life cycle Maturity

52 Demand: relatively flat Little new demand, mostly replacement demand: direct (old customers replacing new products with old ones) or indirect (new customers replacing old customers) Competition: price competition increases Customers more price sensitive Many rivals with sunk investments (emerging overcapacity) Commoditization (less room to differentiate) Firms emphasize cost efficiency (e.g., scale) Cashflow: high cash generation (cash cow) Divert generated cash to stars/? (including

product extensions) Amitai Aviram. All rights reserved. Value pool Product life cycle Decline 53 Demand: declining Product obsolete; needs are better satisfied by other products/markets Competition: severe price competition until rivals die out Reduced demand results in significant overcapacity

Firms emphasize cost efficiency, signaling commitment Cashflow: high but declining cash generation (cash cow) Very little investment in R&D, production or distribution Divert generated cash to stars / ? (including product extensions) Amitai Aviram. All rights reserved.

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