Traditionally, a company’s links to its customers, suppliers and other external parties have been based upon either arm’s-length transactions or socially embedded ties. Electronic technologies have enabled a third and more flexible option, dubbed “virtually embedded ties.”

Companies succeed or fail based on their dealings with others. They purchase raw materials, equipment and parts from suppliers. They sell their own goods and services to distributors, resellers and customers. And they might rely on partners, alliances and industry consortia to provide them with crucial technology or expertise. Indeed, the ability to manage connections to external parties has long been a critical competency for any organization doing business. See sidebar

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Recently, that capability has become increasingly difficult to maintain. Globalization, international networks of companies and various competitive pressures have made out-sourcing, supply chains and customer relationships ever more complex and demanding to manage. At the same time, electronic communications and computer technologies have greatly broadened the possibilities for how organizations might establish and manage such an array of external connections.

In addition to traditional types of connections, such as those facilitated by social relationships, companies now have a new option: “virtually embedded ties,” which are initiated and maintained through electronic technologies like the Internet. Today, organizations should know how best to deploy such connections, and just as importantly, they need to recognize situations in which more traditional ties are the better option for conducting their business transactions.

Three Types of Ties

Since the dawn of capitalism, people have conducted business by establishing two types of external connections: arm’s-length ties and socially embedded ties. The former represent purely economic relationships among individuals and organizations that are otherwise unconnected. These are the rational, faceless and independent connections characterized by the noted economist Adam Smith. Arm’s-length ties are formed solely on the basis of their economic merit, and they last only as long as the transactions around which they are formed. Even today, they still represent a huge portion of all external linkages. Many wholesale and retail transactions, for example, are conducted through arm’s-length ties.

In contrast, socially embedded ties are economic relationships that are underpinned by direct social ties among the people involved. Such connections among professional and social acquaintances, friends, friends of friends, relatives, neighbors and so on can greatly facilitate economic transactions.1 Socially embedded ties develop over time through repeated interactions that emphasize face-to-face contact, such as shared meals, participation in sporting events and volunteer work, and attendance at professional events, including conferences and association meetings. A critical feature of socially embedded ties is that they are multipurpose: Unlike arm’s-length ties, which are focused solely on business transactions, socially embedded ties represent the interaction of people in both commercial and social dimensions.2 Research has demonstrated the strategic importance of such ties in a wide variety of industries, from clothing manufacturing to diamond dealing to banking.3

Along with these traditional forms of connections, changes in society and technology now provide a novel way for companies to create and manage their links to the outside world. Indeed, the vastly improved access to rapid, low-cost sources of information and communication, along with the globalization of many industries, has led to a transformation in the ways that firms connect to external parties. The changes have not only modified arm’s-length and socially embedded ties but have also presented a new option — virtually embedded ties.4 These are external connections that are initiated and maintained through electronic technologies (such as the Internet) and that attain the benefits of socially embedded ties, albeit through different mechanisms. It is important to note that not all electronically mediated connections are virtually embedded ties; many are simply faster, cheaper versions of traditional arm’s-length ties. But those connections that decrease the risk of a transaction by using electronic technologies in specific ways (for example, to increase the transparency of the transaction) offer a powerful new strategic alternative. The competitive advantage of some companies like eBay Inc. and Expedia Inc. is based on their ability to conduct their businesses through virtually embedded ties.

The two types of embedded ties (social and virtual) provide solutions to the same kinds of problems, but two important characteristics distinguish one from the other. First, electronic connections are fast, efficient and inexpensive, and those economics result in the formation of virtual ties that are primarily single purpose. That is, the marginal costs associated with adding a virtual connection is usually very low because existing networks and protocols enable easy and quick access to a vast range of individuals and organizations with specialized information, skills and experience. Although virtually embedded ties can evolve over time to handle more than one function (including social purposes), their economics create a much lower incentive to rely on existing ties for purposes other than that for which they were formed. In other words, the low cost and high speed of searching for and initiating new virtual connections decreases the motivation for companies to rely on existing ties as new needs arise. This contrasts sharply with socially embedded ties, which tend to be multipurpose because they are much more costly to establish.

The second critical characteristic of virtually embedded ties is their reach. Whereas face-to-face interaction and personal referrals tend to favor socially embedded ties within a geographic community (or at least relationships that can include occasional physical proximity),5 virtual connections are not constrained in that way — ties can be formed as easily with someone halfway around the world as with the person next door.

None of the three types of ties — arm’s-length, socially embedded or virtually embedded — presents the one best way for today’s corporations to connect to the outside world. Instead, doing business typically requires a complex web of interconnections that include all three types, and so a crucial task for companies is to maintain and adapt that system to meet changing competitive demands. To manage such a portfolio of connections effectively, though, an organization must first understand the different situations in which each type of tie can provide the greatest efficiency and effectiveness.

Arm’s-Length Versus Embedded

Arm’s-length ties are often the most efficient form of organizational connection, but they have significant limitations in dealing with three potential problems of external relationships: opportunism, uncertainty and complexity. Because of that, embedded ties (either social or virtual) are often a better alternative. (See “Different Types of External Business Ties,” and “Conditions That Favor Different Types of Ties.”)

Different Types of External Business Ties

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Conditions That Favor Different Types of Ties*

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Opportunism

The risk of opportunism — self-interested deception or maneuvering — is high in many external relationships. Here, socially embedded ties have a significant advantage over arm’s-length ties because the trust that stems from interpersonal bonds tends to decrease the possibility of one party taking advantage of another. Such behavior is further discouraged by the potential consequences: The costs of opportunism are not only business related but also personal and social.6

Electronically facilitated linkages might appear to suffer the same vulnerability to opportunism that arm’s-length ties do because both lack frequent face-to-face contact between the different parties. But this is not necessarily the case. Virtually embedded ties limit opportunism not by relying on trust (as do socially embedded ties) but by increasing the widespread transparency of the relationship. In Internet-based relationships, a range of systems (newsgroups, Web-based discussion forums, e-mail lists, online ratings services and so on) help quickly spread information of any disingenuous behavior on the part of suppliers, buyers and other parties. These systems can be very effective because the broad set of values associated with the Internet tends to encourage the frank exchange of information.7 So, unlike socially embedded ties, which increase the costs of opportunism primarily through the damage it might do to specific long-term relationships, virtually embedded ties work mainly through a different route — the potential degradation of an individual’s or company’s reputation, which would adversely affect that person’s or firm’s ability to develop new relationships with others.

Uncertainty

The second critical limitation of arm’s-length ties is that they have trouble reducing the uncertainty associated with a complicated transaction. Arm’s-length ties typically involve minimal information sharing, which is often restricted to just the information necessary to complete an exchange (such as pricing and delivery date). This can be effective for simple deals when the parties fully understand exactly what is being bought (and at what price) and customers don’t need to evaluate the offerings in any depth, for example, the purchase of commodity items such as groceries from a supermarket. But when transactions are more complicated, any uncertainty increases the importance of information. Socially embedded ties meet this need by facilitating the exchange of detailed, proprietary knowledge. In fact, social ties often enable parties to share information they would normally not reveal to others because of its strategic or operational value.8

In contrast, virtually embedded ties facilitate information sharing of a very different nature: the widespread dissemination of relatively detailed information that can be either public or personal. One feature of virtually embedded ties is communication efficiency. Megabytes of electronic data can be transmitted and stored far more efficiently than by more traditional forms of interaction. With a simple click of the mouse, a company can deliver detailed product specs and images to literally millions of potential customers. And the nature of that information also differs from that associated with socially embedded ties. Because virtually embedded ties lack any clear quid pro quo, partners are unlikely to share proprietary information. Instead, they will tend to exchange information that is either public (already available through some other means) or personal (based on their own experiences but not considered proprietary). By facilitating the widespread sharing of such information, virtually embedded ties lower the risk of uncertainty by increasing people’s knowledge and understanding of companies and their products, industry events, and new technologies and trends and their potential impact.

Complexity

The third major limitation of arm’s-length ties is their relative inability to deal with complexity, for instance, in the buying and selling of knowledge-intensive goods and services. Socially embedded ties overcome this limitation by facilitating joint problem solving: people from different organizations working together to solve problems through coordinated analysis and action. As an example, consider engineers who know each other from the same professional association but work for different companies. At a technical meeting of the association, they discover that they are having similar problems with the same manufacturing equipment, so they decide to help each other by sharing data from their respective plants.

Virtually embedded ties help overcome complexity in a different way: through community-based problem solving. Through that process, members of a virtual network help solve a specific problem by, for example, participating in a discussion forum for customers on a manufacturer’s Web site. Such a forum enables people who have experienced problems with the manufacturer’s product to exchange information and tips with others who have had similar difficulties. The combined experience and expertise of numerous users — all shared and archived on the Web site — do not only help customers solve their specific problems but also provide information that the manufacturer can use to improve its products. Online forums do not necessarily have to be focused on specific products; they could, for instance, be devoted to a particular profession.

It is important to note that, when products such as software are purchased through virtually embedded ties, customers are more likely to draw on the community of other users (through the manufacturer’s Web site or some other Internet discussion forum) to help them analyze and resolve problems. But when purchases are based on socially embedded ties, people are more likely to rely on joint problem solving to resolve any issues. The two types of problem solving differ not only in the number of participants but also in the nature of the contributions of those parties. In community-based problem solving the contributions tend to be nonreciprocal and are often relatively minor or fleeting, whereas in joint problem solving the contributions are typically quid pro quo and are more likely to be substantial.

In summary, the effectiveness of arm’s-length versus embedded ties depends on what we refer to as the “severity” of the exchange conditions. When a relationship is fraught with the potential for opportunism and has great uncertainty and complexity, an arm’s-length tie probably will not suffice. The risks associated with the exchange will be too great for any faceless, nameless, one-off relationship. In such cases, either a socially or virtually embedded tie is the better option. The former minimizes risk through trust, sharing of proprietary information and joint problem solving; the latter achieves the same through transparency, widespread information sharing and community-based problem solving.

The insurance industry provides a good example of how socially and virtually embedded ties use different mechanisms to overcome the severe exchange conditions of opportunism, uncertainty and complexity. Independent agents traditionally have relied on socially embedded ties to sell home, life and auto insurance. Working mostly in small offices, these agents typically played a strong role in their communities, sponsoring sports teams and voluntary groups, hosting quasisocial events in which they could explain their products and serving as officers of charitable organizations. The agents could meet numerous potential clients through such activities, and the social contact helped make those people feel more comfortable about purchasing an expensive, important product that they often did not completely understand.

Progressive Casualty Insurance Co., which sells auto insurance online, has taken a different approach. Progressive relies on virtually embedded ties for transparency, widespread information sharing and community-based problem solving to ease people’s anxieties about purchasing insurance policies. For example, the firm’s Web site (www.progressive.com) enables potential customers to compare their current insurance rates against those from many providers, including Progressive. In addition, the site provides a vast array of information tailored specifically to those who are unfamiliar with insurance. The “Teens” page, for instance, provides young drivers with basic information (such as “Insurance 101” and tips for getting a lower premium) and enables them to share their experiences with one another.

Socially Versus Virtually Embedded Ties

As described earlier, socially embedded ties might have the same advantages that virtually embedded ties do, but the two types of connections use different mechanisms to accomplish the same objectives. Each is more (or less) effective in certain environments as a result. Specifically, socially embedded ties have a critical weakness9 in dealing with three types of competitive conditions: network instability, susceptibility to industry restructuring and a need for outside information. Virtually embedded ties offer a better alternative in such situations. (See “Conditions That Favor Different Types of Ties.”)

Network Instability

Because socially embedded ties require a significant amount of time and resources to form and maintain, companies are limited in the number of such connections. That situation can be risky: If a firm’s enduring relationships are severed for whatever reason, it could lack the resources necessary to find and establish replacements.10 This issue is particularly acute in industries characterized by high amounts of turnover, that is, when the average lifespan of existing firms is relatively short and large numbers of new companies are continuously entering the market.

Because virtually embedded ties have lower formation costs, they are better equipped to handle such conditions. Establishing socially embedded ties is typically a gradual process, requiring significant personal interaction, including referrals from third parties. In contrast, the marginal costs of forming virtually embedded ties are relatively low. In fact, companies can use their existing electronic networks to facilitate the rapid and relatively inexpensive creation of numerous ties by, for example, relying on viral marketing and other Internet-based techniques. The exit costs for virtually embedded ties are typically low as well —that is, companies can abandon them easily and inexpensively. In contrast, the exit costs tend to be much higher for socially embedded ties because of the time and resources invested in those ties’ formation. The low costs of formation and exit for virtually embedded ties can greatly lessen a company’s dependence on any particular customer, supplier or partner (or even specific networks of such parties), making the firm less vulnerable in times of industry turmoil.

To appreciate those advantages, consider Computersupport.com, a company that provides technical support to personal-computer users worldwide. (Note: To protect the confidentiality of the participants in our study, we have used pseudonyms.) Computersupport.com relies on a network of virtually embedded ties to suppliers, partners and numerous customers, including thousands of individuals in more than 100 countries, as well as more than a dozen major corporate clients. To manage its relationships with consumers, the company has enlisted a subnetwork of intermediaries, including portals and Internet service providers, that have themselves established networks of relationships with other users, which Computersupport.com can leverage rapidly. Virtually embedded ties also provide much of the company’s infrastructure for its telemarketing, server facilities and investor relations. Lastly, Computersupport.com relies on virtual ties to a range of content partners (online education providers, software manufacturers and resellers, technical publishers, and online retailers) to provide customers with any knowledge that the company cannot supply on its own.

According to the company’s chief technology officer, virtually embedded ties helped to level the playing field in the industry, enabling Computersupport.com to enter the market with less need for a physical infrastructure or other capital-intensive investments. Moreover, Computersupport.com’s network of customers, suppliers and partners takes good advantage of the strengths of virtually embedded ties because the relationships are extremely fluid. The past failure of many dot-com firms, for example, has resulted in significant turnover in the company’s intermediary partners and content providers. Socially embedded ties would have been far too slow and costly to deal with that level of network instability.

Susceptibility to Industry Restructuring

A second potential weakness of socially embedded ties is their susceptibility to disruption following any industry restructuring or transformation. Some markets are relatively protected by comparatively stable technologies or by geographic, economic or political barriers to change. But others can experience rapid, repeated restructuring and dramatic changes, for example, as emerging technologies break down the value of old relationships (mandating the formation of new ones) or as new business models and practices make existing external ties irrelevant.11 In these sorts of industries, virtually embedded ties are particularly effective because they are highly adaptive, which enables companies to shift connections relatively easily and quickly to whatever parties have become strategically important.

Cybertrend Software is a case in point. Founded two decades ago as a developer of printer drivers, the company expanded rapidly both by internal growth and by acquiring the product lines of several competitors. Then, in the early 1990s Cybertrend launched a wireless division. The rationale was that its existing business was becoming commoditized (and hence less profitable), whereas the wireless industry was just taking off and appeared to have limitless potential.

Although Cybertrend had no prior experience in wireless, it was able to establish itself in the market quickly by forming virtually embedded ties with corporate clients, potential partners and mobile carriers. The company used those connections to market its innovative products, which enable the employees of an organization to access corporate information through a variety of wireless devices. Revenues from the wireless products had soon outstripped Cybertrend’s original business, which the company has since divested itself of. According to Cybertrend’s CEO, the speed and reach of virtually embedded ties enabled the company to respond quickly to the emergence of wireless technology to obtain a first-mover advantage. In addition, virtually embedded ties facilitated a fast exit from markets when offerings fared less well than expected.

Need for Outside Information

The third context in which virtually embedded ties can provide a significant competitive advantage is when access to outside information (such as new product ideas and changes in market demand) is particularly critical. In such situations, the problem with socially embedded ties is their tendency to become too tightly bound in a limited network, thereby restricting a company’s flow of information and resources.12 This is a consequence of the high cost of formation and exit of socially embedded ties combined with their multipurpose nature (with each connection typically serving more than one function). Those two characteristics lead to relatively dense networks in which the participants form intensive relationships among themselves and avoid dealings with others.

In contrast, the single-purpose nature of virtually embedded ties (with each connection typically serving just one function) leads to relatively sparse but farther-reaching networks. Through them, companies can engage in broad searches, accessing a wide range of sources to identify a variety of alternatives. Socially embedded ties, on the other hand, tend to limit companies to local searches.

That advantage is amply demonstrated by Central Innovations, which has been providing relationship management solutions to major corporate clients for the past 10 years. The company’s competitive environment illustrates the kind of context in which the crucial need for outside information favors the use of virtually embedded ties.

At Central Innovations, rapid growth and a focus on the middle-tier corporate market have required the company to keep track of what is going on, not only in its own field of relationship management but also across the industries populated by its customers. Without a broad and fluid knowledge base, the firm would not be able to match its offerings to the changing business climates in which its clients compete. According to the chief technology officer of Central Innovations, the company is able to keep on top of those changes (and stay abreast of the technology in its own industry) through a network of virtually embedded ties that connects customers, suppliers and partners. A key element here is an online consortium that provides both customers and employees with access to a broad slate of content, applications and service providers that Central Innovations has identified as credible and leading edge. A series of Web-based hubs for customers, employees and partners provides additional conduits through which new information and ideas can reach the company.

Future Challenges

The Internet and other electronics and computer technologies have revolutionized the way companies and people interact with each other. But they have not rendered traditional forms of connections obsolete. Arm’s-length and socially embedded ties still offer distinct advantages when matched to the right competitive contexts. Most organizations should — and do — use a combination of arm’s-length, socially embedded and virtually embedded ties. But companies in different environments are likely to benefit from using different combinations. When there is a negligible risk of opportunism, little uncertainty and minimal complexity, the efficiency of arm’s-length ties rules. Otherwise, some form of embedded tie will be necessary. The most effective combination of embedded ties will depend on the level of industry volatility: A preponderance of socially embedded ties provides distinct advantages in markets that are stable, whereas virtually embedded ties are better equipped to deal with markets that are not.

The dynamics of external connections represent an ongoing research challenge. In the future, a key contribution will be the detailed analysis of how companies can effectively implement and manage virtually embedded ties. Because of the newness of this type of external connection, people are only beginning to comprehend the resources, skills and strategies that are necessary to leverage it fully for competitive advantage. One key question is the amount of control that firms can exert in managing their portfolios of external connections to ensure that they have the ideal mix of virtually embedded ties working in complement with both arm’s-length and socially embedded ties.

Throughout the history of commerce, companies have had to strategically create, skillfully negotiate and carefully manage networks of connections to customers, suppliers, partners and other external parties. But the challenges (and opportunities) created by the Internet and other electronics technologies have dramatically amplified the need for organizations to understand just what kind of connections are most effective and efficient given certain industry conditions. As the global economy increasingly relies on both information technologies and interorganizational networks, the strategic combination of arm’s-length, socially embedded and virtually embedded ties will become all the more crucial for the competitive advantage of companies.

References

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6. B. Uzzi, “Embeddedness in the Making of Financial Capital: How Social Relations and Networks Benefit Firms Seeking Financing,” American Sociological Review 64 (1999): 481–505.

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8.A. Larson, “Network Dyads in Entrepreneurial Settings: A Study of the Governance of Exchange Relationships,” Administrative Science Quarterly 37 (1992): 76–104; and B. Uzzi, “Social Structure and Competition in Interfirm Networks: The Paradox of Embeddedness,” Administrative Science Quarterly 42 (1997): 35–67.

9. B. Uzzi, “Social Structure and Competition in Interfirm Networks: The Paradox of Embeddedness,” Administrative Science Quarterly 42 (1997): 35–67.

10. U. Andersson, M. Forsgren and U. Holm, “Subsidiary Embeddedness and Competence Development in MNCs — A Multi-Level Analysis,” Organization Studies 22 (2001): 1013–1034; T. Rowley, D. Behrens and D. Krackhardt, “Redundant Governance Structures: An Analysis of Structural and Relational Embeddedness in the Steel and Semiconductor Industries,” Strategic Management Journal 21 (2000): 369–386; and B. Uzzi, “Social Structure and Competition in Interfirm Networks: The Paradox of Embeddedness,” Administrative Science Quarterly 42 (1997): 35–67.

11. C.M. Christensen, “The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail” (Boston: Harvard Business School Press, 1997); and A.J. Hoffman, “Institutional Evolution and Change: Environmentalism and the U.S. Chemical Industry,” Academy of Management Journal 42 (1999): 351–371.

12. T. Rowley, D. Behrens and D. Krackhardt, “Redundant Governance Structures: An Analysis of Structural and Relational Embeddedness in the Steel and Semiconductor Industries,” Strategic Management Journal 21 (2000): 369–386; and H. Yli-Renko, E. Autio and H.J. Sapienza, “Social Capital, Knowledge Acquisition, and Knowledge Exploitation in Young Technology-Based Firms,” Strategic Management Journal 22 (2001): 587–613.