Why do small businesses fail?

Posted by on March 2, 2010 in entrepreneur

Although small business starts appear to be consistent regardless of the economic cycle, many people are forced into entrepreneurship during downturns. Some will succeed. Others will fail. Why a small business succeeds or fails is often a subject of great debate and academic research.

As a general comment, economic conditions, in and of itself, is not a prime reason for business failure. In fact, more than half of the 2009 Fortune 500 companies and nearly half of the 2008 of Inc. Magazine’s fastest growing companies were start up businesses which began during an economic downturn. Opportunity and risk are opposite sides of the same coin. More practically speaking, downturns tend to lower the cost of labor and goods- key expense controls for any business.

As to specific reasons why businesses fail, I would suggest the following as some major reasons:

Negative attitude of the owner manager. Owing a business is like being in a relationship. You can fake that everything is ok for so long but people will figure it out. Negative attitudes about business prospects, the good or product or, most importantly, self-image of the owner manager will doom the business. Ever meet an owner manager of a store who was rude to you? Most likely, it was because they do not like their business and they were taking it out on the customer. You would not shop at that shop again would you? Since it is a “soft skill”, it is often overlooked but successful entrepreneurs are positive (almost to a fault). Watch an interview with any successful business person. They are upbeat about themselves and their business. It is contiguous and their employees begin to emulate it too.

Failure to follow a plan- much less have one. Entrepreneurs typically figure out who among their colleagues are doing well. The successful ones have a really boring plan they are following with appropriate adjustments. The not as successful, but much more exciting, entrepreneurs are bouncing from plan to plan, idea to idea. Too often their emotions override a well-thought out plan, they don’t have the patience to follow a plan or they don’t have a plan in the first place. It is very similar to an investor with no investment plan. They just keep buying willy-nilly with often poor results.

The key is to think of the exit before you enter. Are you building to sell? Operating until you die? Building as a hobby which makes money? If an entrepreneur never had an exit strategy to start out with, best to think of one now and plan towards it.

Failure to understand the market. In the simplest sense, are you selling quantity or quality? If you sell quality, you should never engage in a race to the bottom in pricing and if you are selling quantity, you cannot necessarily spend too much time/money on the customer (this is why cell phone companies treat us properly; pricing wars have turned minutes/data into commodities. It has moved to a high volume, low margin business).

Determining the market is key since it should anchor how the business sells (mass advertising or targeted marketing-for example, Tiffany’s only advertises in high-end mediums), what expenses it incurs (retailer make little so they pay their staff little) and where it should expand.

Once this is figured out, what is the sales cycle of your customer/client? Is it fast (a dollar store), medium (website design) or long (selling anything to large corporate clients)? One needs to figure out sales cycle because…

Failure to understand cash flow cycles… dooms businesses from a dollars and cents perspective. For example, assume a business has accounts receivables aging, on average, at 45 days at a 95% realization rate (in other words, it takes, 45 days to be paid and 5% is never recovered), the business has to negotiate terms with suppliers or obtain credit from lenders or have sufficient cash to either pay the supplier on 45-60 day terms or have the cash or credit facilities to bridge between the time paying the supplier and when the business is paid. At a 95% realization rate, the business also cannot spend 100% of profit since not all sales will be collected. If the owner-manager is not a numbers person, it is strongly advisable to hire a good book-keeper who not only keeps the books but spots these trends (my belief has always been that a good book-keeper provides more value than a good accountant in the early days of a business since accountants are generally too backwards looking and the cash is all gone by the time they spot the mistake).

Lack of good talent management. This is my sin. Entrepreneurs are DIY to the extreme or, because they are so close to all facets of the business, they tend to delegate poorly or assume their employees have the same understanding and provide them with instructions under this assumption (he writes looking guilty).

The entrepreneurial saying is “sell what you are good at and buy what you are not.” It hurts to spend money on something the owner manager knows it can do but one has to leverage time properly towards the greatest revenue generating activities and nurture employees to support these activities.

Burnout. Entrepreneurs are, by heart, micro-managers. The issue with this is that taken at the extreme, it can cause the entrepreneur to resent the business (see negative attitude); King Henry VII of England notated and initialed every single ledger entry (mostly rent rolls from Crown lands) to ensure no one cheated him. He died the wealthiest King of England in centuries but was utterly miserable and alone.

My overarching advice is ask for help. Entrepreneurs as a community are always willing to help one of their own. One would be surprised how receptive entrepreneurs are to helping one another.

I also wanted to end with my favorite quote on entrepreneurship by Paul Gram: “Running a start-up is like being punched in the face repeatedly…But working for a large company is like being waterboarded.” Good luck to all the entrepreneurs out there.

3 Comments on Why do small businesses fail?

By Kyle on March 2, 2010 at 8:30 am

Great article, I recently started a small, very small, side business that I am trying to get going. I think another important factor is DRIVE. If you you don’t have the drive to work your tush off, at least at the beginning, you are going to have a hard time succeeding.

By The Rat on March 2, 2010 at 12:04 pm

Nice post; I think it is relevant because small business are the backbone to our economy. You highlight some very valid reasons as to why businesses fail.

By LinkStuff For Sunday, March 7 on March 7, 2010 at 6:19 am

[...] Thicken My Wallet has some ideas about why some small businesses fail. [...]

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