A global blueprint for midsize companies.

Facing powerful forces to globalize, midsize firms can tap overseas opportunities, such as a rising global middle class, but they must also contend with increased political, economic, and cultural risk.

While global markets have long been a reality for small and midsize companies (SMEs) from Europe and Asia, North American firms of the same size were largely content to operate in their own large home markets until the 1980s. Some exceptions were biotech and high-tech firms, which needed to offset their massive R&D costs with a global network of research contracts.

In the past decade, however, SMEs at all technology levels have ranked globalization as a top priority. A 1997 survey of middle market companies, conducted by Yankelovich Partners for Deloitte & Touche, polled 100 senior financial executives in firms with revenues between $100 million and $1 billion; 61 percent of these companies were public, and 29 percent were private. The quest for expansion was one of their two top concerns, together with staff recruitment and retention, and globalization in particular was the highest issue of continuing concern.

WHY GLOBALIZE?

Three major forces are driving this trend for SMEs:

* Higher rates of market growth overseas, and especially in big emerging markets such as Brazil and China. Despite the current turmoil in Southeast Asia, long-term prospects for developing economies remain positive. In East Asia alone, the middle class will soon reach 500 million. While China's 1.2 billion population is still dominated by a rural, largely nonmarket group, as many as 300 million Chinese are now classified as middle class and concentrated on the coastal "golden crescent" between Beijing and Guangzhou. For this rising middle class, many products that have reached saturation levels in the U.S. or Europe are still at an early stage of their life cycle. Cola consumption, for instance, reaches almost 400 annual servings per capita in the U.S., versus less than 100 in France and less than 10 in China.

* Globalization of competitors is leading to an increasing penetration of the U.S. market by foreign companies. Japanese car makers opened the way in the 1970s, and Asian and European companies of all sizes are now increasingly targeting the large and relatively unprotected U.S. market as their top priority. A survey of the German Mittelstand (midmarket) companies found that 97 percent were represented in the U.S.. Faced with intensifying competition at home, SMEs therefore have a powerful second incentive to expand their own base of operations.

* Regional trade agreements, such as NAFTA or the European Union, are also making it easier for smaller companies to operate within these zones. In many sectors ranging from automotive parts to electronics, companies can manufacture in Mexico and re-export to the U.S. under NAFTA; conversely, harmonization of EU product standards and regulations has smoothed the way for SMEs entering the European market.

HOW AND WHERE TO GLOBALIZE?

One major change that occurred in the late 1980s and 1990s is the entry point and mode chosen by SMEs. While their traditional approach was incremental (progression from exports to licensing or joint ventures, for instance), SMEs now tend to "leapfrog" the process and launch immediately into an equity joint venture or an acquisition, thereby increasing risk as well as potential returns. This is driven in large part by a shift in entry points. While SMEs' traditional first steps overseas were often in Canada or other English Commonwealth countries (due to these countries' geographical or cultural proximity), many are now opting to enter Latin America, Eastern Europe, or Asia. In addition to market potential and lower production costs, the appeal is also due to the wave of privatizations that started in Latin America and Eastern Europe in the early 1990s, and is now continuing in places such as China.

These trends often dictate entry modes for SMEs. In China, for instance, most companies have no choice but to enter through an equity joint venture with a state-owned company, or, less often, with a wholly owned subsidiary. In Latin America, privatizations in sectors such as telecom and energy present attractive acquisition opportunities and are driving a shift from exports to foreign direct investment.

This pattern is confirmed by a database of more than 500 companies set up during a collaborative multi-year program between Columbia Business School and Deloitte & Touche. Of 340 Deloitte & Touche client companies tracked in 1997, for instance, fully 46 percent had an on going global expansion initiative. In this group, 40 percent were primarily targeting emerging markets (most often Mexico, Brazil, and China), versus only 32 percent aiming toward developed countries; the rest had multi-region expansion programs.

Given the significant degree of risk affecting emerging markets - made especially salient by the current crisis in Southeast Asia - SMEs, even more than large multinationals, need to include a comprehensive risk assessment system in global planning.

MINIMIZING RISK

Forecasting risk is a notoriously difficult process, even for experienced multinationals. Major risk assessment services failed to predict the Mexican peso devaluation and the Asian currency crisis, even though there were clear warning signs in these countries, such as current account deficits of more than 8 percent of GDP, high levels of dollar-denominated debt and high ratios of non-performing to total bank loans in Asia.

A comprehensive risk assessment method should therefore combine secondary sources and direct management contacts in the target country. Besides addressing the macroeconomic and political outlook, this process should also cover "soft" issues such as cultural incompatibilities, which are at the source of many alliance and acquisition failures. In China, for example, due to different expectations from each party, the equity joint ventures advocated by the government have had a high rate of failure.

Risk assessment should therefore cover:

* Political/legal issues (government stability, corruption, intellectual property protection, civil unrest, etc.)

* Economic outlook (macro indicators, income disparity, privatization, etc.)

* Financial situation (currency risk, exchange controls, taxation, etc.)

* Trade and investment conditions (trade agreements, tariff/non-tariff barriers, local content rules, production/market share quotas, ownership requirements, etc.)

* Sociocultural issues (labor skills, costs and availability, work ethic, time orientation, attitudes toward the West, etc.)

This risk assessment should, of course, be part of a larger planning process designed to optimize the timing and entry point/mode choices for a midsize firm.

A STEPWISE PROCESS

Many SMEs still start their international expansion in an opportunistic mode, with decisions often driven by CEO contacts, offers from overseas, or triggering events such as privatizations. Research indicates that most successful players instead follow a systematic approach that includes the following five steps:

1. Resource assessment. Given the significant commitment in time, personnel, and funding required by international expansion, companies should first assess their own resources (international experience and availability of management, training requirements of an overseas partner if one is already known, and financial commitment required). Even leading multinationals can overlook this crucial step. When Microsoft tried to establish Windows software as China's standard, it underestimated the dearth of local programmers and ultimately had to set up more than 70 high-cost alliances with local universities and research centers to train programmers.

2. Market/competition/risk analysis. While the timing of an international expansion should be decided in step 1, the choice of an entry point largely depends on a triple assessment - quantification of the market opportunity, competitive intensity, and level of risk involved in any given country. This step often facilitates a decision between several targeted locations. While most firms conduct a market analysis, many do not balance it adequately with a parallel assessment of competitive intensity and risk level. For example, a pharmaceutical firm lured to the Indian market by its 250 million middle class population may underestimate the problem posed by local generic competitors, who are protected by the fact that the government does not enforce intellectual property regulations.

3. Portfolio decisions. Given an SME's limited resources, it generally would do well to follow the German Mittelstand model of product/market resource allocation. Most German midsize firms have a broad geographical scope, but a highly focused product range, usually in industrial sectors with a limited number of global customers. For example, ProMinent, with only DM230M in expected 1998 revenues, has 27 foreign subsidiaries and sees itself as the world's top supplier of small electronic pumps.

4. Choice of entry modes. To the extent possible, a partnership with an experienced local group greatly facilitates an SME's foreign entry. It shares risk, accelerates the transfer of market knowledge, and establishes instant supplier and customer relationships. The optimal progression would be from an initial non-equity alliance to an equity joint venture, but, as noted above, government regulations do not always allow this entry sequence.

5. Monitoring process/exit strategy. Finally, a close monitoring process should be put in place; this should include the option of an exit strategy, given the high failure rate of international ventures for firms of all sizes.

Globalization will continue to be a top concern for small and midsize companies, but the level of risk, as well as opportunity, presented by the largest, most attractive locations requires a systematic and sequential approach to these markets.

Francoise Simon is professor of international business at Columbia Business School in New York and president of the SDC Group, an international consultancy.