Kerin - Business Survival

  • Date:01 Mar 2016
  • Type:Company Directors Magazine

Professor Paul Kerin considers the life expectancy of organisations and finds that corporate immortality is an unrealistic goal.

Business failures have received much media attention recently. The long-term evidence on business life expectancies is sobering and reinforces the need for businesses to maximise returns while they can. Of course, the business failure rate depends on how we define both “business” and “failure”.

Most economic research focuses on companies above a minimum size (to eliminate the noise from the very high failure rates of small and/or unincorporated businesses) and on “catastrophic” failures (businesses ceasing to exist due to bankruptcy or liquidation), as they are directly observable. In a typical year, less than 0.5 per cent of companies experience catastrophic failure.

However, company failure rates are really much higher. In a typical year, about 1 per cent of companies voluntarily cease operations due to financial underperformance. Most directors would view such cessations as failures. Therefore, the real annual company failure rate is 1.5 per cent.

However, even that doesn’t reflect all failures. Companies that become insolvent and enter administration, but subsequently survive, aren’t included. Neither are companies that fail to earn adequate returns for multiple years – except in the year that they cease operations.

While failure is behind many company cessations, many more cessations result from factors (such as being acquired) that aren’t necessarily failure-related. Company survival rates are lower than we might think. Only two-thirds of companies survive five years. Half survive 10 years. A fraction – 1 per cent – survive 100 years. Only about 5,500 companies older than 200 years still exist on earth; only 50 are more than 700 years old.

Companies are like human beings. We all have significant control over our own life expectancies. But there is some probability that uncontrollable factors will kill us in any one year. The wonders of compounded probabilities mean that no matter how well we look after ourselves, we will die eventually.

So too, with companies. We can help our companies survive by making good strategic, operational and financing decisions, adjusting to industry changes and managing risk with respect to macroeconomic shocks. But we can’t completely eliminate risk. Every company will cease to exist at some time; it’s only a matter of when. A decade ago, Kongo Gumi – then the world’s oldest company – entered liquidation (aged 1,428 years), due to a combination of poor choices (high debt) and unfavourable industry conditions.

Business size is not a panacea. Almost 90 per cent of all companies older than a century employ less than 300 people. The long-term combined average annual exit rate from the S&P/ASX 100 due to either corporate collapse or inadequate total returns to shareholders is about 1.5-2.0 per cent. This means that 20 years from now, over 30 per cent of companies would have exited the ASX 100 for either of those reasons alone. And more would have exited due to acquisitions.

Only two-thirds of companies survive five years. Half survive 10 years.

Of course, the rise and fall of businesses is good for our society. It’s all part of what economist Joseph Schumpeter called “creative destruction”, which helps drive efficiency and progress. More businesses are created than are destroyed. Although the median life expectancy of companies (10 years) is less than that of humans, research suggests that companies have more control over their life expectancies than humans do. Macroeconomic and industry factors do contribute to company failure rates; however, most failed companies have not managed their controllable factors as well as they could have. Therefore, while they still need luck on the uncontrollable factors front, companies that manage their controllable factors well can live longer than any human. Indeed, the key original rationale for incorporation was to create legal entities that could outlive their owners.

However, maximising shareholder value should be a company’s main objective. Our own knowledge that death is inevitable and its timing uncertain motivates us to enjoy life while we can. Likewise, companies should maximise shareholder value while they can. That doesn’t mean they should be reckless. For most companies, shareholder value is largely driven by the next 10-20 years of cash flows; taking care of our companies so they can realise that cash is important. Corporate immortality is an unrealistic goal.

Professor Paul Kerin
Head of the School of Economics
University of Adelaide