Organizational Failure

Avoiding organizational failure may not seem as exciting as achieving organizational success. However, it is a part of the job of the board, and the managers. Sound strategic planning helps governing directors and top managers to agree a way to meet these duties.

What do I mean by organizational failure?

Ideas of enterprise failure in use range from, failure to earn an economic rate of return on invested capital, given the risk of the business, to legal ruin followed by liquidation of the firm's assets.

Organizational failure as a legal process

One way to think of corporate failure is the recorded and dated entry of a body into some legal process, such as Chapter 7 or Chapter 11 of the US Bankruptcy code, or their like in other places. Chapter 7 covers corporate liquidations and Chapter 11 covers corporate reorganizations, which usually follow a period of financial distress.

Under Chapter 11, management must file a reorganisation plan, in a bankruptcy court, and seek support for this plan. When the court grants approval, the firm can resume trade.

However, in many cases, investors and suppliers of the troubled firm lose out financially in such restructures. In other cases, the shake-up only delays Chapter 7 liquidation.

Organizational failure may mean a body simply ceasing to operate as an independent entity.

Organizational failure is not that simple.

When is a failure not a failure?

Surely simply counting business exits would give us an idea of failures. Not all business exits are organizational failures.

U.S. Census Bureau's Characteristics of Business Owners (CBO) and U.S. Census Bureau's Business Information Tracking Series (BITS) provide figures that explain the state of the business when it ceased.

As shown in the pie chart, business success, as percent of new employer firms after four years, showed that about half of new businesses remained open for a reasonable time. About a third of all closed businesses closed while successful! Against common belief, not all closures are failures. Only one-third of new businesses stopped because of lack of business success.

While few publicly quoted companies fail in any given year, strong firms tend to take over weaker firms.

Confusion over the rate of corporate failures

Various sites on the internet had these statements -

"…The Small Business Administration (SBA) keeps the stats on business failures and claims that more than half of new businesses will disappear in the first five year…”

“…Statistics show that 8 out of 10 new businesses fail within the first three years…”

“…A study done by Inc. magazine and the National Business Incubator Association (NBIA) revealed that 80 percent of new businesses fail within the first five years…”

“…80% of new businesses fail within their first year."
What a gloomy picture for would be start-ups!

A more hopeful picture on organizational failure

When we take a closer look at the figures from the US SBA, we get these fractions of new businesses founded in 1992 still operating in following years.

The picture is not quite as scary as the oft-quoted 80% after five years.

Organizational failures are less common than many people think

An extensive study by the Australian Productivity Commission found that - "Contrary to common perceptions, most Australian businesses survive for a considerable time. In this jurisdiction, around two-thirds of businesses are still operating after five years and almost one-half are still operating after ten years. Around 7.5 per cent of businesses exit each year. Cessations account for around 80 per cent of exits, with changes in ownership accounting for the rest.

Most exits are not firm failures

Less than 0.5 per cent of businesses exit each year due to 'catastrophic' company failure, such as bankruptcy or liquidation. The failure rate has fallen significantly in the past decade, with the estimated failure rate at 3.6 failures per 1000 enterprises in 1999-00, one-third of that rate in 1991-92.

When we think of organizational failure as 'going out of business', we might not feel so bad, because the facts are not as bleak as some media headlines suggest.

Each year, exits account for, at most, between 9-10 per cent of total job losses. However, in net terms, the gains from new business start-ups outweigh these impacts. The entry rate for new businesses runs about two-thirds higher than the exit rate.

Looking at exit rates is not the only way to think about organizational failure.

Death, disease, and organizational failure

Just as an organism, such as a human being, can be alive, and continue to survive in a fashion, disease can take its toll on the ability of the individual to function effectively. It may shorten their life, as well as reduce the quality of their life.

In a like way, an organization may be continuing to exist as an independent entity, giving the appearance of being viable. However, it is at risk of decline or collapse into being wound up as an organizational failure, the equivalent of death for an organization.

Thus, two organizations may show a similar financial journey towards failure. One enterprise may 'turn-around', whilst the other may fail.

Many parties including the intended beneficiaries have an interest in the health of organisations. These include the shareholders in the case of businesses, providers of debt finance, employees, suppliers, customers, managers, and auditors. Corporate failure can impose big financial and other personal costs on all these groups. Even where reorganization of a company averts total failure, the costs of doing this can prove to be very heavy, and compromise the ability of the firm to trade out of its problems.

Identifying signs of possible failure early enough to allow successful intervention, may reduce these costs. Various models, based on analysis of financial accounts, exist for predicting business failure.

Signs of coming organizational failure

There are usually warning signs of coming organizational failure. Failure is usually the result of mostly visible flaws, and avoidable errors in the processes leading to eventual collapse or disaster. Usually there is a climate providing scope for these errors to spread, and this climate discourages people from drawing attention to the mistakes.
So where do we watch for the symptoms that might alert us to something going the wrong way?

What should you be looking for?

Corporate organizational failure can arise for many reasons. It may be a single catastrophic event. It may follow a lengthy process of decline. Under the second perspective, corporate failure is a process, which starts with management defects, leading to poor decisions, leading to financial deterioration, and finally corporate collapse.

The areas to monitor for possible symptoms include those things John Argenti found to be present in his analysis of a number of major corporate failures. He documented these findings were in his book: Corporate collapse: the causes and symptoms, 1976. Argenti clearly identified six symptoms of organizational failure.

This is the list, widely regarded as almost universal truths -

  1. One-person rule: CEOs whose drive help a firm to grow at early stages, sometimes find it hard to change to a more professional, team managed enterprise. Their initial strength becomes an obstacle to sound management of a larger firm.
  2. A non-participating board: a passive board can warn of failing corporate governance.
  3. An unbalanced top team: people like to work with people of similar outlook. However, diverse abilities help the organization to deliver on its promises to intended beneficiaries like shareholders.
  4. A lack of management depth: Broad experience, as well as intellect is important.
  5. A weak finance function: No organization can sustain itself for long if no one is monitoring the cash flow. Focusing on short-term profits may be a strategic error. Cash, asset, and risk management are critical to long-term viability. A strong Chief Finance Officer (CFO) must go beyond being a historian, and contribute to the top team strategic thinking as well as prepare clear reports for governing directors.
  6. A combined chair and chief executive officer.

Prevention is better than cure

Detecting trends to corporate decline is important. However, operating the organization in a way that avoids corporate failure is the way to go whenever possible.

Lessons from the study of collapse include the necessity of having capable managers, and professional management systems. These systems adequate accounting systems, and reporting to the governing directors. It is vital that boards have a clear idea of what they are responsible for, and what information they need to do their jobs.

Naturally, I think that one of the most crucial systems is strategic planning!

Earlier I said that the widespread view that a high percentage of businesses fail each year, was incorrect. Only a small proportion of them cease by way of a catastrophic failure. However if we look at failure as failing to deliver satisfactory levels of benefit, to the intended beneficiaries of the organization, then perhaps a quite large proportion of organizations are failing!

Many organizations fail in one, or both,
of two dimensions

Firstly, they may fail to deliver sufficient benefit to the primary interest group or beneficiary group. This includes the owners of a business, the students of an educational organization, and patients of a hospital and so on.

Secondly, in pursuing their fundamental purpose of delivering benefit to their intended beneficiaries, they may fail to behave well towards them, or to any other groups with a legitimate interest in the activities of the organization, whether customers, employees, or other groups involved with the enterprise.

An organization may be achieving good results, and behave badly while doing so. An enterprise may behave in an exemplary fashion, while delivering poor or mediocre results, and so on. This diagram shows the various possibilities for failure and success.

You will not be surprised to learn that I strongly believe that one of the most useful tools for improving both corporate results, and corporate conduct is strategic planning.

The framework in the diagram shows one of the strengths of the Argenti System of Strategic Planning. I believe it is unique in holding intended results together with good corporate conduct.

In the figure above, the governing directors provide the boundaries for the central area.

On the vertical axis of the graph, the governing directors provide the boundaries of desired corporate results, with targets for minimum and satisfactory performance levels. The minimum level of performance, labelled 'failing', is that at which, the directors would consider removing the CEO from office. Then they set a target above this minimum level, at which they would deem performance above the minimum to be satisfactory. Above this is excellent or fantastic performance.

On the horizontal axis, we see another range set by the governing body. This is for conduct of the enterprise towards its interest groups, including the intended beneficiaries. The minimum in this case is the 'no harm' principle. The range above this that is more satisfactory is the positive and constructive engagement of the interest groups, in achieving the fundamental purpose of delivering benefits to the intended beneficiaries. Above this level is exemplary, where the organization has become the benchmark for others.

Strategic planning focused from the start in this way, can give organizations some improved protection against failure of the catastrophic sort. It can also improve the probability of improved performance to a significant degree.

Return from Organizational Failure to Organizational Effectiveness.

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