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Past Issue • Jan-Mar 2016

When Do Firms Invest in Developing Rookies? Answering the Make vs Buy Question on Human Capital

In order to augment human capital, firms have the option to either build the talent by hiring novice employees and developing them inside the firm or to hire experienced employees from other firms. Recent trends suggest they are pursuing both options to have some mix and balance of both strategies without necessarily considering the tradeoffs. In this paper AJ Chauradia analyses firms that pursue both strategies, and then investigates when their attributes can inform effective governance of one strategy vis-à-vis the other. The main empirical results suggest that a firm possessing slack resources is more likely to pursue building compared to acquiring strategies.

A 2011 government survey reports that firms have been pursuing building and acquiring strategies in relatively equal proportions (Jones & Rothschild, 2011). Additional publications of trends in the legal industry from 1999 to 2008 show that law firms build and acquire in relatively equal proportions. However, pursuing both human capital (HC) strategies in equal proportions does not automatically govern employees (Wang, He, & Mahoney, 2009), and may not increase a firm’s economic returns (Chauradia, 2014). According to Cappelli (2008: 13), how firms strike a balance between building and acquiring “differs across organisations and operations depending on internal capabilities.” Therefore, a strategy to pursue both human capital strategies needs to align with a firm’s attributes that make it conducive to earn a competitive advantage from this mix. The purpose of this paper is to investigate a firm’s internal attributes that can effectively govern and guide a firm’s decision to differentially rely on building vis-à-vis acquiring strategies.

In order to evaluate the decision to build versus acquire, popularly termed as “make versus buy” (Cappelli, 2008: 119), we compare the transaction costs of these two strategies (Argyres & Zenger, 2012; Mahoney, 2005; Williamson, 1975). Novice employees under development are typically paid lower wages than laterally acquired experienced employees because of the novice employee’s lack of general HC (Becker 1976; Bidwell, 2011; Mayer, Somaya, & Williamson, 2012; Milgrom & Roberts, 1992). However, the costs to maintain a training system, in which novice employees are in development for several years, is much higher compared to the costs of integrating an experienced employee (Goldberg, 2007; Stroh & Reilly, 1994). In addition, the costs of recruiting a novice employee may also, counterintuitively, be substantially higher than that of an experienced employee in HC-driven firms (Goldberg, 2007; Kimball, 2006). Therefore, the overall costs of these two employment relationships can be very expensive even though they differ in the allocation of the costs. Second, since both strategies entail recruiting employees of uncertain quality and inducing them to invest in the firm’s HC (Akerlof, 1970; Chauradia, 2014), novice and experienced employees can both equally be opportunistic. Firms face ex ante adverse selection and ex post moral hazard problems in both strategies (Arrow, 1974; Mahoney, 2005). Therefore, distinguishing which strategy leads to a competitive advantage based on their relative transaction costs is not clear.

The existing literatures often leave out important factors in the building vis-à-vis acquiring decision, and, more importantly, do not discuss the unique drivers of each strategy. Based on our analysis, we identify two unique drivers that may comprehensively explain when firms rely more on building than acquiring strategies: the degrees to which firms can engage in (1) mentorship and (2) long-horizon investments. Mentorship is defined as a firm’s capability to provide its employees with knowledge, guidance, feedback, and support in order to develop them (Coff, 1997; Payne & Huffman, 2005; Russell & Adams, 1997; Zachary, 2005). Long-horizon investments are a firm’s capability to pursue HC investments that, by definition, take a long period of time to pay off (Souder & Bromiley, 2012; Souder & Shaver, 2010), and under which novice employees will be initially less productive.

Based on these two theoretical drivers we generate hypotheses that can provide insight into when building seems more logical than acquiring. We also hypothesise situations in which firms may not be able to pursue mentorship or long-horizon investments, and thus are more likely to rely on acquiring strategies. We test our hypotheses in the context of the legal industry in which the decision to build or acquire continues to be debated in practice (Lat, 2013; Manch, 2000), and which has undergone strong influences by legal institutions, the economic environment, and firms’ strategic actions (Galanter & Henderson, 2008; Galanter & Palay, 1991; Gilson & Mnookin, 1989; Henderson, 2010; Malos & Campion, 1995; Qualters, 2009; Shah, 2005).

A strategy to pursue both human capital strategies needs to align with a firm’s attributes that make it conducive to earn a competitive advantage from this mix.

We make three contributions in this paper. First, we theorise two drivers–mentorship and long-horizon investments–in order to explore the question of why firms differentially rely on building vis-à-vis acquiring, a choice that is of interest to HC management scholars (Cappelli, 2008; Coff & Kryscynski, 2011; Menon & Pfeffer, 2003; Wang, He, & Mahoney, 2009). Second, we attempt to address the problem of choosing between augmentation strategies based on firm attributes that can effectively govern employees. Third, the unique nature of our data allows us to measure both building and acquiring strategies, which has been an empirical challenge.

Theory and Hypotheses

Mentorship

The two factors that can help distinguish between building and acquiring strategies are a firm’s capability to provide mentorship and to pursue long(er)-horizon investments. Mentorship broadly focuses on the collaboration and exchange of knowledge among experienced and inexperienced colleagues (Allen et al., 2004; Ostroff & Kozlowski, 1993), and is an important aspect of training and development (Zachary, 2005). IBM requires colleagues of different age and skill-levels to interact and thus mentor each other to bridge gaps in leadership, experience, diversity, and generations for their HC development (Murrell, Forte-Trammell, & Bing, 2008). The largest knowledge gaps exist in junior-level colleagues; such gaps are often closed by senior-level colleagues who have the expertise to provide coaching, guidance, and advice (Coff, 1997; Emelo, 2012; Payne & Huffman, 2005; Russell & Adams, 1997; Viator & Scandura, 1991).

When firms bring in HC to maintain the knowledge hierarchy they are more likely to pursue building than acquiring strategies. The excess supply of managers helps distribute the work so that each manager has less to do, and thus they are more available to support mentorship of novice HC. One of the primary costs of mentorship is the time and attention that these managers would otherwise devote to their clients. HC-driven firms can utilise this excess expertise towards the development of novice employees to potentially improve their firms’ future performance. These firms would also be less likely to pursue acquiring, since experienced HC need less mentoring, and thus the firm would not be able to take full advantage of its excess supply of managers.

Hypothesis 1: Ceteris paribus, the greater the managerial slack, the more likely a firm will rely on building than acquiring strategies.

Long-horizon investments

Long-horizon investments can characterise HC since a firm’s investments in HC can take significant time to pay-off (Souder & Bromiley, 2012; Souder & Shaver, 2010). Building strategies are more of a long-horizon investment compared to acquiring strategies because (1) it often takes 3-5 years before firms recover their investments from their building strategies and because (2) firms spend significant time developing their novice HC in order for them to be productive in the future (Benson, Finegold, & Mohrman, 2004; Cappelli, 2008: 116; Loewenstein & Spletzer, 1997). Attempting to speed up the process internally through increased spending or allocation of additional resources can lead to time compression diseconomies and the ineffective development of these HC (Dierickx & Cool, 1989; Pacheco de Almeida, Henderson, & Cool, 2008). Firms that pursue acquiring strategies typically have a shorter payoff period. Experienced HC are likely to possess more readily deployable skills and make fewer mistakes after they are integrated into the firm (Campbell, et al., 2012; Mayer, et al., 2012), thus making them almost immediately productive (Chadwick & Dabu, 2009).

When firms bring in HC to maintain the knowledge hierarchy, they are more likely to pursue building than acquiring strategies. The excess supply of managers helps distribute the work so that each manager has less to do, and thus they are more available to support mentorship of novice HC. One of the primary costs of mentorship is the time and attention that these managers would otherwise devote to their clients. HC-driven firms can utilise this excess expertise towards the development of novice employees to potentially improve their firms’ future performance.

HC-driven firms with financial slack are more likely to pursue building strategies. Financial slack enables these firms to pursue long-horizon investments because the firm has a financial buffer in case the investment does not deliver acceptable economic returns. By contrast, firms with low levels of financial slack will generally favour acquiring strategies, because these strategies are much less of a long-horizon investment. In such cases, firms are not in position to wait for the deferred payoffs and would rather possibly upgrade their competitive position by immediately acquiring experienced employees (Souder & Shaver, 2010).

Hypothesis 2: Ceteris paribus, the greater the financial slack, the more likely a firm will rely on building than acquiring strategies.

External leadership

Firms often bring in external leaders, defined as managers, which the focal firm hired from another firm. These external leaders can either build a new team or bring their own team. Firms that pursue external leaders to lead a new area of business or to manage the opening of a new office are more likely to pursue acquiring strategies (Kor & Leblebici, 2005). These firms that pursue both external leaders and acquiring strategies can address the quality uncertainty and team complementarities problems associated with generating economic returns (Chauradia, 2014). Also, these firms are more likely to pursue acquiring strategies when bringing in external leaders because less mentorship is needed and less of long-horizon investments is involved. First, firms do not need to provide additional mentorship since the relationship between the managers and employees remains intact, thus allowing for the continued sharing of team-specific mentorship that originally led these managers and their teams to be productive at their prior firm (Groysberg, 2010). Second, these firms can take advantage of immediate economic returns with this strategy, a process that otherwise takes substantial time and resources in order to generate team complementarities (Chauradia, 2014; Groysberg, Lee, & Nanda, 2008).

Hypothesis 3: Ceteris paribus, the greater its acquisition of external leaders, the more likely a firm will rely on acquiring than building strategies.

Turnover shocks

A turnover shock is a negative disruption to a firm’s current activity that may stem from a combination of involuntary turnover (firm-led) and voluntary turnover (employee-led) that in the end results in an excessive loss of HC (Dess & Shaw, 2001; Glebbeek & Bax, 2004; Shaw, Park, & Kim, 2013). While firms may be able to absorb small disruptions to their HC, a turnover shock may need to be handled more carefully in order to offset any departure-related interruptions, restore current operations, and prevent poor productivity. Firms that have experienced a turnover shock may be less likely to pursue long-horizon investments because they cannot wait for a large cohort of inexperienced employees to develop their HC while the firm’s very survival is threatened. Also, senior-level colleagues may not be able to spend time mentoring because they will be preoccupied in dealing with the repercussions of the turnover shock, such as understanding and working on any of the former departed employees’ unfinished projects. If the turnover shock results in the loss of at least 20 percent of the firms’ employees, the impact would be tremendous in terms of expended resources, employee time, and discontinuity in services or production, thus increasing the appeal of pursuing acquiring strategies to quickly recover from it (Kimball, 2006).

HC-driven firms with financial slack are more likely to pursue building strategies. Financial slack enables these firms to pursue long-horizon investments because the firm has a financial buffer in case the investment does not deliver acceptable economic returns.

Hypothesis 4: Ceteris paribus, when a firm experiences a turnover shock, it is more likely to pursue acquiring rather than building strategies.

Data and Variables

This paper uses a firm-level panel dataset from the legal industry to assess the impact of HC augmentation strategies on a firm’s economic returns. We constructed a large dataset by combining a number of different surveys of the largest US law firms, which includes all firms in both the Am Law 200 published by the American Lawyer and the NLJ 250 published by the National Law Journal. Am Law 200 annually ranks the top 200 revenue grossing law firms that self-report their revenue and net income, which is cross-checked by the American Lawyer’s staff reporters. NLJ 250 ranks the largest 250 law firms based on the total number of permanent fulltime equivalent attorneys. The final sample consisted of 133 firms and 490 observations from four surveys observed longitudinally.

Building ratio

The dependent variable is the ratio of building strategies to total hiring strategies. Following prior research (Chauradia, 2014; Kor & Leblebici, 2005), building strategies are measured by the number of entry-level associates that a firm hires. Total hiring strategies is the sum of building and acquiring strategies, which is measured by the number of lateral mid-level associates that a firms hires in a given year.

Managerial slack

Managerial slack is measured by the inverse of the average leverage ratio for the last three years. This measure captures the extent to which firms have managers available to provide mentorship to their employees.

Financial slack

Previous studies have measured financial slack by the firm’s return on equity (ROE) (Bourgeois, 1981). In law firms, the equivalent to ROE is profits per partner or PPP (Chatain, 2011; Kor & Leblebici, 2005; Maister, 1993). Therefore, financial slack is measured by the firm’s average net income over the previous three years divided by the average number of partners over the previous three years.

External leadership ratio

External leadership ratio is measured by the number of partners a law firm laterally acquires divided by the total number of partners promoted inside the firm.

Turnover shock

A turnover shock differs from regular turnover of employees since a shock suggests a significantly larger impact to the firm. Therefore, we developed this as a dummy variable with values of 20%, 25%, and 30% of HC losses compared to the total number of attorneys inside the firm.

Controls

We use a firm fixed effects model for the longitudinal data that implicitly controls for unobserved firm-level variations that do not change over time. In addition, we include year dummies that control for year-to-year variations. We also control for firm size by the number of attorneys in the firm, and include controls for associate-to-partner turnover, layoffs, and geographic diversification.

Model specification

Since our dependent variable is a fraction, it is appropriate to use a statistical model that accounts for this. However, since our sample is a selection of firms, the fixed effects aspect is very important to proper modeling. Therefore, we estimate a fixed effects regression model with an AR (1) disturbance to test our hypotheses. We reject the null hypothesis (p < 0.01) for the Hausman test, which suggests fixed effects, is more appropriate to use than random effects. The model below shows the dependent, independent, and control variables.

Building ratioi,t+1 = f [β1*Managerial slacki,t + β2*Financial slacki,t + β3*External leadership ratioi,t + β4*Turnover shocki,t + β5*Total attorneysi,t + β6*Associate-Partner turnover ratioi,t + β7*Layoffi,t + β8*Geographic diversificationi,t + β9-14*Year fixed effectsi,t + β15*Constanti,t]

Where i represents a law firm and t represents time. The full sample runs from 2003-2009. In addition to the AR(1) model, we perform additional statistical analyses that are not shown (i.e., clustered fixed effects, fractional logit, and two-limit tobit), and the results are similar for most of the hypotheses.

Result

The results show when firms are more likely to invest in building than acquiring strategies. We find support for the first three hypotheses. Both managerial and financial slack are attributes that enable firms to provide mentorship and pursue long horizon investments, and thus be able to invest more in building strategies. When firms have less attributes to provide mentorship (i.e., they bring in external leaders who are expected to provide economic returns to the firm immediately), a firm is more likely to pursue acquiring strategies. We find that financial slack is statistically significant when we split the sample by highly leveraged firms. Alternatively, managerial slack, external leadership, and turnover shock is statistically significant when we split the sample by minimally leveraged firms. These additional findings suggest some important underlying boundary condition for employee governance that needs to be further explored.

Conclusion

In conclusion, this paper looks at the antecedents of when firms pursue building vis-à-vis acquiring strategies. To corroborate our findings and address this limitation, we include interviews and conversations with law firm partners, who are constantly struggling with the build versus acquire choice. According to a partner at a large law firm, associates “get[ting] regular feedback from the partners who [they] work directly for” is critical to the mentorship process. Building strategies are also more of a long-horizon investment since, novice associates’ billable time often needs to be written off while they are in training (Hillman, 1997). However, after some time when these associates are mentored, they are “less likely to make substantive errors or incorrect choices of procedure” especially “when the benefit of someone with more experience is available” in case these associates need assistance (Lawpro, 2002: 22). Therefore, managerial slack and the ability to pursue long-horizon investments are important factors in a firm’s decision to build.

*This paper was accepted in the Best Paper Proceedings of the Academy of Management. It was also nominated for the Best Conference Paper Prize at the Strategic Management Society conference and a finalist (1 of 5) for the Best Conference Paper Prize within the Strategic Human Capital interest group.

ABOUT THE AUTHORS

  • aj

    AJ Chauradia

    Assistant Professor of Strategy at the Indian School of Business (ISB).
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