Duke Research Advantage

Duke Strategy Professor Will Mitchell’s insights on business failure.

Times are tough and businesses are going bankrupt. I do not need to remind anyone that we are in a tough economic period – in the U.S. and throughout the world – and that many firms have either failed or on the point of failing. In the U.S., the American Bankruptcy Association reports that business bankruptcy filings were up more than 40% in the first half of 2008 versus the same period in 2007, to more than 18,000 filings. The third and fourth quarter statistics will almost certainly be even worse. Several high-profile cases involving the possible failure of U.S. auto manufacturers are front and center in the media, as well as here in discussions on this Duke Research Advantage blog.

Failure hurts more than shareholders. In addition to shareholders, bankruptcy clearly causes losses for employees, suppliers, and the communities in which a firm operates – whether the bankruptcy involves full dissolution (Chapter 7) or is part of business reorganization (Chapter 11). Each of us can look at our local communities and at friends and families to see the losses and hurt that business failure can cause.

Should we keep failing businesses from failing? So, the big question is how hard we should seek to avoid business failure? Like most questions of this sort, the answer depends on who the “we” is.

Avoid failure by creating profitable value. People throughout a firm have every incentive to bust most parts of their bodies – and especially their minds – to find the resources they need to stay in business. Of course, the best way to stay in business is to create value that customers want to pay for, even in tough economic times (see the four-part series that Rich Burton and I posted last week). Profitable value is by far the best drug for business survival. It is my job as a teacher in a business school classroom to help students gain the skills that they need to keep their companies alive by creating profitable value.

Is the economy better off if we use public subsidies to keep failing firms from failing? But what if a firm’s best efforts to create profitable value fail – should the firm lobby for and receive public support to stay afloat until times get better? After all, isn’t the public welfare better served by keeping a firm going – to provide jobs, keep firms in the supply chain alive, and support local communities? Moreover, even a struggling firm often has components that are highly valuable, whether desirable products, long term R&D activities, organized supply chains, and complex distribution systems. Business failure might appear to threaten to throw out the valuable components along with the struggling parts of the business. Should we conclude, then, that the economy is better off if we provide public subsidies that keep struggling firms alive, especially firms that historically were strong, in hopes that they will return to strength when the economy recovers?

Perhaps surprisingly, that answer is usually “no.”

Firms struggle because they are not creating enough value. Firms that once were profitable begin to struggle for a reason – most strikingly, they have been unable to create a business model that provides profitable value in a given economic climate. Sometimes, the core problem is weak management. Perhaps more often, the problems stem from structural impediments that even the most thoughtful managers have been unable to overcome (the U.S. auto companies are good examples of this, in which structural impediments arising from health costs as well as upstream and downstream supply chain lock-ins have been the major causes of continuing failure).

2+2 = 3 is bad math for firms and for countries. Whether the overall problems stem from bad management or structural barriers, many businesses simply are not as valuable as their parts. That is, in its current form, the business is adding 2 to 2 and getting 3. This is suboptimal for the firm and, just as importantly in terms of public policy, bad for the economy.

Learn from Japan. Over time, an unwillingness to let failing firms fail can badly damage an economy. The most obvious recent example is Japan, which sunk into a decade-long recession in large part because it was unwilling to take on the focal pain of letting high profile firms break up once they were no longer were able to lead their markets. Instead, an ongoing series of corporate band-aids and public aid projects protected businesses that had been world leaders in the 1980s but had become laggards, if not dinosaurs, in the 1990s. Outpaced by more innovative firms based in Korea, Europe, Southeast Asia, the Middle East, and the U.S., the inability and unwillingness of Japanese leaders to restructure their corporate goliaths damaged the economy – including the employees, suppliers, and communities that the aid efforts were attempting to protect.

Failure helps 2+2 become 5 when the market supports reorganization. One of the amazing strengths of the U.S. economy is the ability to actively reorganize firms through the market – both through formal bankruptcy reorganizations and, most importantly, through active mergers, acquisitions, and divestitures of whole companies and parts of companies. The reorganizations help move valuable components of struggling businesses to new homes, in which new leaders can use them to make 2 plus 2 add up to 4 or, better yet, 5.

Acquisitions are good for economies. Business acquisitions and divestitures have a bad reputation in many circles. We can all recite stories in which acquisitions destroyed value and damaged lives. In practice, though, acquisitions and divestitures are an essential part of an active and healthy market economy. Last year, almost 30,000 business acquisitions took place around the world, with a value of more than $3 trillion, according to Thomson/SDC. While some of these combinations failed, many were essential to moving under-performing assets into new homes, with the potential of creating new value. Economies with active business acquisitions markets tend to be more adaptive and dynamic as global conditions change.

Acquisitions have become global. The U.S. has historically been a leader in acquisition and divestiture reorganization. In the past decade, though, Western Europe has caught up and, in some years, surpassed the U.S. in acquisition activity (either in numbers of deals or financial value). Equally strikingly, acquisitions have become an active part of business strategy in many emerging markets around the world, including Central Europe, Brazil, and much of Asia.

Not bought or sold in Japan. Japan is the one major exception to acquisition growth. Although Japanese firms are active buyers and sellers when they operate away from home, many have been reluctant to engage in active acquisition strategies at home (although there are important exceptions, such as the Japanese pharmaceutical industry, which has been using domestic acquisitions to catch up to world leaders). In 2007, Japan announced just over 2,000 deals (about the same number as in each of the much smaller economies of Canada and Australia), compared to about 11,000 deals in each of the U.S. and Western Europe. Again, this unwillingness to reorganize has contributed to the country’s difficulty in overcoming the doldrums of the 1990s, as we discussed above.

Allow failing firms to fail. So, the bottom line, in my view, is that we should encourage reorganization of failing firms via bankruptcies and/or business acquisitions rather than prop them up, for the health of the economy. Just as my job in the classroom is to help students learn how to create profitable value, my job as a policy voice is to allow encourage public officials to allow those of my students who not been able to create value to fail, so that they and the resources in their firms can go on to new efforts to create profitable value.

Educate people rather than prop up failing firms. At the same time, let’s be honest – bankruptcy and acquisitions will hurt individuals and the communities in which firms operate. Instead of using public resources to support failing firms, however, we are better off using those resources to support education, training efforts, and mobility that allow people to upgrade their skills and, if necessary, go where the jobs are. It is this upgrading of skills that leads to long term health for both individuals and economies. I will pick up on this point in a later post.