Business Valuation
Apr 29, 2023
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This guide explains organic growth vs inorganic growth. We’ll explain the difference between them and explain how each form of growth takes place. This guide covers concepts about mergers and acquisitions. If you’re not familiar with the M&A process, we recommend our guide: The M&A Process Explained. Here is a summary of the difference between organic and inorganic growth:
Organic growth happens when a business focuses on improving core operations. Some key contributors to organic growth are sales and marketing efforts, product improvements, and team building strategies. When done well, these have the effect of growing revenue and scaling the business’ operations through increasing output. Revenue grows organically in only four general ways.
1. Getting more new customers through marketing & selling efforts.
2. Increasing the number of times those customers spend money with the business.
3. Increasing the amount of money they spend—the average order value of each transaction.
4. Referrals and affiliates.
The concept being that when we’re trying to drive organic growth, we want more new customers, we want them to buy from us more times, spend more money with our business, and refer more business to us. Ultimately any strategy you’re considering to boost revenue organically will fall into one of these four categories.
It’s important to note that there is more to organic growth than just driving more sales. Moving beyond revenue growth, the business must still be able to fulfill its orders. So, growing sales alone won’t scale a business because the business still needs to be able to increase their outputs to fulfill those orders. Imagine customers paying for something that never comes. That’s obviously not a sustainable growth strategy.
So, improving the product, growing a team that can handle the workload, and expanding operations along with sales is a necessity part of organic growth as well. This is what people mean when they talk about “scaling” a business.
Inorganic growth is an alternative way to grow a business.
Inorganic growth comes from M&A transactions as opposed to growing core operations of the business. The idea here is that we can increase the value of the business, its cash flow, and market share without organic growth. Here’s an example of value created through inorganic growth from our guide on Financial Synergy:
The basic idea is that after the merger or acquisition the resulting business will be better than it was before. Here’s an example to illustrate this: if Company A is valued at $200m and buys Company B for $50m, and the resulting company is valued at $350m—we look at the merger or the acquisition as what created that additional $100m value (above the combined value of each of the businesses individually). [See our guide: Financial Synergy for more on this.]
Here we can see that this transaction resulted in an additional $100m in value created. Inorganic growth is sometimes sought after because it is faster than organic growth for larger, more established businesses. The assumption being that the M&A deal will probably take less time to complete and to integrate than it would take to grow $100m in value organically for a business currently valued at $200m. Alternatively, organic growth may be faster for smaller businesses, and will almost certainly be a more sustainable long-term growth strategy (more on this below).
When companies grow to a certain size, market share becomes a bigger concern to them as they approach the limits of their TAM (Total Addressable Market). Sometimes buying a competitor is the most efficient way of capturing more market share.
Now that we understand the difference between organic and inorganic growth, let’s look at why a company would focus on one type of growth strategy versus the other.
Most likely the type or mix of growth strategy a company employs depends on their size and maturity.
Here, we'll look at why smaller businesses generally focus on organic growth over inorganic growth—and then we'll look at larger businesses.
Generally speaking, for smaller companies, organic growth is the only sustainable growth option they have. It’s also the only one that makes long-term sense. To better understand this concept, there are two main classes of buyers in M&A—financial buyers and strategic buyers. You can learn more about the distinction here—but financial buyers are usually private equity companies or large financial institutions. Strategic buyers are companies—usually in the same industry—that buy smaller companies that help them to grow their core operations.
When we talk about organic vs inorganic growth, we're comparing two growth strategies for strategic buyers. Financial buyers have a core business model based on acquisitions, so this concept doesn't really pertain to them.
There are two main reasons why smaller businesses focus on organic growth strategies over inorganic.
We will explain these in detail with accompanying infographics.
First, small businesses can grow organically at a significantly faster rate than large companies can. It is much harder for Apple to grow revenue 50 percent over last year than it is for a business doing $3 million in sales. The business doing $3 million may only need to close a handful of new customers to achieve that growth—Apple would need far more.
To understand organic growth, you have to understand constraints. Small businesses can grow faster than large businesses because the constraints on that growth are normally not related to the size of their market.
To understand constraints on growth, we'll look at small and large businesses.
When a new business (small) brings a product to market, they are first concerned with achieving product-market fit. The idea here is that they have something for sale and it costs something. A business achieves product-market fit when customers accept that value proposition (they deem the product/service is worth the price) en masse. Small businesses then need to figure out how to sell that product/service (or product line) at a profit. The challenge here is more than profitability. Businesses need to figure out a customer acquisition strategy that creates a positive cashflow cycle and minimizes any working capital funding gaps—meaning that they can afford to grow organically.
Small businesses often find organic growth faster because these constraints are not based on market potential. They're based on making better value propositions (product or service offers), creativity, and some learnable skill sets (ie. selling, marketing, copywriting, etc.). Additionally, growing 20 percent means fewer new dollars earned for a business doing $3 million in revenue, than a business doing $3 billion.
The second reason that small businesses focus on organic growth is they don't have access to the same debt funding that established businesses with consistent, stable cashflow have. The majority of M&A deals use some form of financial leverage (using debt to help pay for the acquisition). M&A is not a sustainable growth strategy without deal financing. We'll look at this more below.
Because of these two factors (faster growth stage and limited access to debt funding) the growth strategy for an early-stage business will often focus entirely on organic growth.
On the other end of the spectrum, a very old, large, established business may have difficulty with organic growth. This is because the constraints on the business are different at their stage. Large, established businesses that have been around for decades may be reaching the limits of their total addressable market (TAM). Meaning that the issue with growth is that they are limited by the size of their market.
However, to offset this, they may be well-capitalized. For these larger businesses it may make more sense to pursue inorganic growth strategies.
To master this concept, we'll look at the business life cycle (illustrated below):
Here, we can see the lifecycle of a normal business. It starts with the launch phase, and over time the business matures. In the end, it either declines, or it finds a way to innovate and continue growing.
The takeaway here is that its obvious that the more established business has stronger, more consistent cashflow and profitability. This translates to a better ability to secure debt funding, which we'll explore here.
Normally when a company wants to make an acquisition, they will use leverage to finance the transaction. You can learn more about leverage here, but “leverage” in finance, means the use of debt in a transaction. So, if Company A buys Company B for $100m, and $35m is paid for in cash, and $65m is borrowed, then the transaction was 65 percent leverage.
Its substantially harder for small businesses to get debt funding than it is for larger more established companies.
This is because risk goes down with maturity and businesses with no proven track record are considered to be a much higher risk to investors.
This concept is almost universal in lending. Here’s an example from everyday life. Say you owned an apartment you were looking to rent out at $3,000/month. You have two potential renters, one with $100,000 in provable income and an 800 credit score, and another with no job who doesn’t want to have his credit checked. Which tenant is less risky to rent to?
Actually, it’s kind of a trick question, because we have no way of truly knowing. The renter with no job could have a huge trust fund and the other guy could lose his job next month.
The point is that lenders perceive proven track records, consistent earnings, strong cash flow, and good credit to be ways of mitigating risk. Statistically they are—and to the degree that the overwhelming, vast majority of lenders adhere to these standards.
Startups don’t have a long history of earnings, a proven track record, or consistent cash flow. Larger, more established businesses do. This is why lenders will lend enormous sums of money to multi-national corporations, but the best options a small business has are revolving lines of credit and credit cards.
The illustration below illustrates the relationship between risk and debt.
Organic growth strategies are what makes start-ups and medium-sized businesses grow. As companies mature, access to debt and declining growth rate percentages can make inorganic growth strategies more attractive.
Inorganic growth strategies are more attractive to large, established companies. Additionally, lenders prefer lending to them. They often have proven track records, consistent earnings, and stronger cash flow. This all comes together with the fact that mature companies have less room for organic growth—making inorganic growth a strategy to consider for mature corporations.
A final distinction on organic vs inorganic growth: Some strategists see joint ventures and strategic partnerships as inorganic growth strategies. We don’t classify them as inorganic, because in practice, they usually result from sales and marketing efforts and usually contribute to sales (core business operations) and those customers will go on and have a lifetime value to business owners.
We see this as organic growth and in the end of the day, joint ventures and strategic partnerships are really sales and marketing, distribution, or product enhancement strategies.
