How is the Selection Mechanism of Firms Functioning?

Current Situation of the Selection Mechanism of Firms

How is the natural selection function currently (as of 2006) working? Analysis was conducted using data from Tokyo Shoko Research (TSR). This data includes information (sales and profits over three fiscal periods, number of employees, year established, grading and etc.) on and the exit status (survival, bankruptcy, dissolution, business closure, suspension, merger and etc.) of around 800,000 firms (from micro and small to mid-sized and large firms).

The results of the analysis show that the total exit rate (bankruptcy, dissolution, business closure, suspension and mergers) is higher among firms with low profitability (profit margin on sales), firms with low growth (growth margin on sales), as well as firms with poor financial standing (grading). This confirms that the natural selection function is working normally from the perspective of profitability, growth and financial standing, and suggests that the selection function of the market has changed since the latter half of the 90s.

Characteristics of the Exit Mechanism of Firms

Analysis next focused on how the selection mechanism of firms differs according to size, age or inter-firm relationship (business relationship or shareholder relationship). The exit of firms is categorized as follows. Of the aforementioned exit types, bankruptcies that hurt creditors are thought of as “late” exits, while dissolution, business closures and suspensions are considered “early” exits. Mergers can also be considered early exits, but this is an “advanced” exit where ability to arrange a firm to merge with is necessary. Differences in the selection mechanism are analyzed from three categories.

First, differences in the exit rate according to firm size are as follows. It was confirmed that the smaller the firm the higher the exit rate from dissolution, business closure and suspension, and the larger the firm the higher the exit rate from mergers. The sum of exit rates from dissolution, business closure, suspension and mergers is lower among firms with sales in the hundreds of millions of yen (millions of US dollars) and follows a U-curve. On the other hand, it was found that late exit from bankruptcy follows an inverted U-curve. It is estimated that late exits will increase if the early selection mechanism does not function properly.

Next, observed differences in the exit rate according to firm age show that the younger the firm the higher the total exit rate. Looking at exits by type confirms higher merger and dissolution exits among younger firms, higher bankruptcy exits among firms 10-19 years old, and higher business closure exits among firms 40-49 years old. The selection mechanism varies with firm age.

In addition, observed differences in the exit rate according to the inter-firm relationship show fewer early exits (dissolution, business closure and suspension) when recognized by other firms as a major business partner. As a result, “late” exit (bankruptcy) increases. On the other hand, early exit (dissolution, business closure and suspension) increases and mergers are arranged when there is an external majority shareholder firm.

Strength of the Natural Selection Function

Differences in exit rate according to firm size, age and inter-business relationship are next confirmed from the perspective of strengths of the natural selection function. Natural selection function strengths are defined from the two perspectives of profitability and growth. The former is defined by how much higher the exit rate is for unprofitable firms compared to profitable ones. Similarly, the latter is defined by the exit rate difference between firms with low and high growth.

It was observed that the strength of the natural selection function varies according to firm size, age and inter-business relationship. The larger the firm the stronger the natural selection function from the perspective of profitability. On the other hand, it was found that natural selection functions better in smaller firms from the perspective of growth more than profitability. Looking at differences in the strength of the natural selection function according to firm age shows that, from the perspective of profitability, the younger the firm the stronger the function in early exits. From the perspective of growth, however, natural selection functions in younger firms and firms 40-49 years old. The exit of 40-49 year-old firms is thought to involve business succession, but whether to pursue business succession is decided from the perspective of growth rather than profitability.

Lastly, we look at natural selection function strength according to the inter-business relationship. As mentioned above, there is less early exit when recognized by other firms as a major business partner. This trend, however, is particularly notable among firms with low profitability and growth, and the natural selection function in early exit is weakened. Business relationships are not desirable from the perspective of weakening the natural selection function. When considering that building business relationships requires a certain degree of costs, however, the exit of firms is significant in the sense they lead to the collapse of business relationships. Considering the adverse effects that the exit of firms can have on business partners, it is also important to keep the entire networks of firms in mind.