The Truth About Small Business, and How to Get Yours Off the Ground

“Do 9 out 10 new businesses fail, as Rand Paul claims?” – The Washington Post’s website, last January

“Five Reasons 8 out of 10 Businesses Fail” – a Forbes article from last year

“The Venture Capital Secret: 3 Out of 4 Start-Ups Fail” –WSJ

“Top 6 Reasons New Businesses Fail” –Investopedia

It seems everywhere you look there is new evidence that small business are floundering. Why do small businesses fail? It’s an interesting question. The idea that small businesses fail with regularity is pervasive, and it fits with our image of the entrepreneur. We see her as a risk-seeker with the guts to roll the dice even when all odds are stacked against her. This mental image gives the 9-5 crowd a sense that they made the right choice. According to the numbers, their entrepreneurial friends are making a huge mistake.

We’re comfortable thinking that Entrepreneurship, while sexy, is not worth the risk. But is it true? Is entrepreneurship really the gamble it seems to be?

No. At least, not in the way we often talk about it around the water cooler. In a paper published in Small Business Economics, Brian Headd, from the Small Business Administration’s Office of Economic Research, divulges the real numbers for small business closure:

…76 percent of new firms were open after two years, 47 percent after four years and 38 percent after six years. These rates are substantially different than what is still commonly believed; more than ten years after the publication of [these statistics], individuals still call the U.S. Small Business Administration looking for the unknown source of the alarming sound byte that 9 out of 10 businesses close in their first year.

Those number, the real numbers, come from a 1989 paper by Bruce Phillips and Bruce Kirchhoff (also of the SBA), but as Headd points out even these statistics are pessimistic. They do not take into account closures that were positive, intentional events.

Headd found in his research that after 4 years into their new venture only 33% of owners will have closed unsuccessfully. Indeed it seems that the numbers reported by experts on the subject vary wildly depending on the chosen definition of “failure”. If you define failure as bankruptcy for example, almost no small businesses fail, whereas about 8 in 10 will undergo some form of “discontinuance of ownership” according to Australian business management experts John Watson and Jim Everett. In their 1996 paper “Do Small Business Have High Failure Rates?” they reviewed the expert literature on the topic and discovered that expert estimates of failure rates vary from 1 to 9% per year, depending of the definition of failure.

Even after we take into account how we define failure, failure rates are hardly consistent across business types. New manufacturing enterprises are 25% less likely to close than new service or retail businesses, and new services industries are about 3 times as likely to close, while successful, as retail industries.

Clearly the story about small business success is more complicated than: ‘starting a business is unbearably risky, and only the insane and gifted should even try’. But even after arriving at the truth of the matter, being an entrepreneur still bears some risk. So, what can new business owners do to reduce the chances of closing unsuccessfully?

Headd notes in his paper that businesses are more resilient if they have employees, more than $50,000 in startup capital, and multiple owners with experience owning a previous business. Other indicators of resilience include being home based, having founders with bachelor’s degrees, and being started for personal reasons instead of financial reasons. He explains that being home-based, while indicative of lacking resources, is a good sign that the owner takes “staying lean” seriously – an important factor in resilience. All of these factors, especially having startup capital and being an employer, were also associated to one degree or another in an owner’s perception of success if a venture did end up closing.

On the other hand, the factors that negatively influence a business’s longevity are relatively young owners, a lack of startup capital, and being in an urban/suburban environment. Headd’s reasoning on that last point is particularly interesting, saying “Young owners and individuals in urban/suburban areas may be more likely to have better business or job opportunities. Owning a business comes at a higher opportunity cost for them, and they may therefore be more likely to close the business.”

If you are stressed about whether or not your startup will survive, know that the numbers are actually in your favor. Even if your venture fails, the downside has little resemblance to the popular conception, and there is always the permanent upside of having tried and gained the experience and connections to help with your next venture.

References

Headd, B. (2003). Redefining business success: Distinguishing between closure and failure. Small Business Economics, 21(1), 51-61.

Phillips, B. D., & Kirchhoff, B. A. (1989). Formation, growth and survival; small firm dynamics in the US economy. Small Business Economics, 1(1), 65-74.

Watson, J., & Everett, J. E. (1996). Do Small Businesses Have High Failure Rates?: Evidence from Australian Retailers. Journal of Small Business Management, 36, 45-62.

Watson, J., & Everett, J. (1999). Small business failure rates: choice of definition and industry effects. International Small Business Journal, 17(2), 31-47.