Why Small Businesses Fail

Success in business is never automatic. It isn't strictly based on luck - although a little never hurts. It depends primarily on the owner's foresight and organization. Even then, of course, there are no guarantees.

Starting a small business is always risky, and the chance of success is slim. According to the U.S. Small Business Administration, over 50% of small businesses fail in the first year and 95% fail within the first five years.

In his book Small Business Management, Michael Ames gives the following reasons for small business failure:

• Lack of experience
• Insufficient capital (money)
• Poor location
• Poor inventory management
• Over-investment in fixed assets
• Poor credit arrangements
• Personal use of business funds
• Unexpected growth

Gustav Berle adds two more reasons in The Do It Yourself Business Book:

1. Competition
2. Low sales

More Reasons Why Small Businesses Fail

These figures aren't meant to scare you, but to prepare you for the rocky path ahead. Underestimating the difficulty of starting a business is one of the biggest obstacles entrepreneurs face. However, success can be yours if you are patient, willing to work hard, and take all the necessary steps.

One fact reported by SBA this year has been that "8 of 10 small business start-ups are no longer in existence after five years due to lack of management knowledge and skills." While I realize that "no longer in existence" does not translate into "absolute failure" it appears that the "8 of 10" is extremely high. These are troubling statistics.

Six Most Common Blunders That Lead to Failure

Blunder 1: Amount of Effort Exerted

The single most important factor in determining who succeeds and who doesn't is simply the amount of effort exerted. If you aren't ready and willing to work - and work hard - being an entrepreneur is probably not for you. For starters, most people are used to working and 8-to-5 job, with a "boss" directing them. When you're in business for yourself, you must have the discipline to work independently. You must maintain the same work schedule of the same number of hours virtually every day even if you don't have anything scheduled.

Also, many people assume that when they own their own business, they'll be able to work less and take more time off for recreation. Unfortunately, the opposite is true. When you run your own business, you usually have to work more hours, not fewer. You have to be willing to put in long hours and, if necessary, work weekends as well. This is especially true in the start-up stage.

Blunder 2: Inadequate Financing

A considerable number of people have unrealistic expectations when it comes to the funds needed to start a business. They often lack the necessary start-up funds and can't come up with adequate financing. Furthermore, a considerable number have virtually no cash or liquid assets and expect either a bank or the Small Business Administration (SBA) to provide 100 percent financing. In most instances, neither a bank nor the SBA will provide someone with financing unless that person is investing a significant portion of his or her own funds, boasts a good credit record and has the means to pay back the loan.

Most people wrongly assume the SBA will provide them with 100 percent financing based solely on their good ideas. But if someone has no cash at all, it usually reflects poorly on his or her ability to manage finances -something the SBA takes into consideration. Funds may be derived from cash savings, personal credit lines or family loans.

Blunder 3: Lack of Planning

Another fact rarely considered is that the majority of new businesses fail within a few years mostly due simply to poor planning or no planning at all. Most people who go into business enter a field related to their current employment or a favorite hobby. They don't do a market study first to see whether the demand for their product or service is growing, declining or stagnating.

They also fail to allot the proper time for administrative tasks. Most new business owners assume the majority of their time will be spent producing and marketing their product or service. Unfortunately, this isn't the case. An inordinate amount of time is spent on administration - talking on the phone, purchasing supplies and equipment, filling out government forms, and taking care of other mundane duties. Internet business-to-business services are helping to cut down the time factor of some of these duties; however, it's still a relevant oversight.

Blunder 4: Unrealistic Expectations

Many individuals assume not only that most businesses succeed, but that they're lucrative from the get-go. This is definitely not the case. Generally speaking, it usually takes at least a year to develop a profitable business. The first year's goal is usually earning back your investment. Even then, the money has to be reinvested in the business. In other words, in your first year, you should have other sources of income to live on.

Blunder 5: Inability to Commit

Even though most people would like to start their own business, only a small percentage actually do it. When push comes to shove, most lack the self-confidence to make a decision and act on it. In order for the business to succeed, they must be able to gather information, weigh the facts and then make a prompt decision.

Blunder 6: Unwillingness to Take Responsibility

A business owner is 100 percent responsible for his or her mistakes. There's always a risk of a business failure or less-than-expected financial return. If that should happen to you, you can't blame it on someone else. If you would like to start a small business, you must thoroughly and objectively analyze the feasibility of your idea. Failure to do so can have a tremendous personal cost on finances, relationships and family ties.

So What is Business Failure? How can you tell when your business is going to fail, and make corrective action? Business failure is the last stage of an organization's life cycle. Organizational decline, leading to failure is characterized by management who has become reactionary. The result is inadequate or nonexistent planning and inefficient decision-making. The most common reasons for business to underperform (low productivity, low profits) or fail (bankrupt, cease being) are as follows:

• Poor cash flow management.
  
  
• Absence of performance monitoring.
  
  
• Lack of understanding or use of performance monitoring information.
  
  
• Poor debtor management. A combination of not paying your debtor on time and not coordinating payments with incoming cash flows.
  
  
• Overborrowing. The company is overleveraged and debt is not being reduced.
  
  
• Over reliance on a few key customers.
  
  
• Poor market research leading to an inaccurate understanding of the target customers wants and needs.
  
  
• Lack of financial skills and planning.
  
  
• Failure to innovate.
  
  
• Poor inventory management.
  
  
• Poor communications throughout the organization.
  
  
• Failure to recognize your own strengths and weaknesses.
  
  
• Trying to go it alone. Trying to do everything yourself and not seeking external help. Whether this external help be as simple as hiring additional staff or going to professional services such as a lawyer, accountant, banker or business coach.
  
  
• Younger companies are more likely to go bankrupt because of shortcomings in managerial knowledge and financial management abilities. In contrast, older firms are more likely to fail because of an inability to adapt to environmental change. These are the conclusions of a new research paper that examines factors underlying corporate bankruptcies, and compares the main causes of failure between young and old firms.
  
  
• It sounds simple, but the number one reason why businesses succeed or fail is because the business owner did not take the time to conduct a feasibility analysis, market and business plan. Why? Sometimes an idea is developed that the business owner thinks is good but no one else does. Sometimes an idea is formulated that the business owner believes is so good that the potential customers will find it themselves. And sometimes the business owner thinks that everyone is a potential customer.
  
  
• A clear and consistent finding of prior research is that firms face the highest failure risk when they are young and small. But if there are factors other than the liabilities of newness and smallness that contribute to firm failure, what are they and how can their influence be mitigated? From the perspective of the resource-based view of the firm, firms will fail if they are unable to generate self-sustaining levels of organizational rents. For new firms, the critical challenge then is to establish valuable resources and capabilities before initial asset endowments are depleted. Among older firms, which have survived the liabilities of newness, it is imperative to ensure that resources and capabilities continue to provide value as the competitive landscape changes. Thus, we should observe different causal mechanisms between firms that fail early and those that fail at a later stage. Young failures should be attributable to inadequate resources and capabilities (relative to initial endowments). Older failures should be attributable to a mismatch between resources and capabilities and strategic industry factors.
  
  
• The main reason for failure is inexperienced management. Managers of bankrupt firms do not have the experience, knowledge, or vision to run their businesses. Even as the firm's age and management experience increases, knowledge and vision remain critical deficiencies that contribute to failure. A second key deficiency occurs in the area of financial management. Some 71% of firms fail because of poor financial planning. Three particular problems that arise in this area are an unbalanced capital structure, an inability to manage working capital, and undercapitalization. Both old and young bankrupt firms suffer this deficiency. This confirms other findings that initial problems in financial structure are difficult to overcome and continue to haunt firms as they age. This study suggests that the underlying factor contributing to financial difficulties is management failure rather than external factors associated with imperfect capital markets. Many bankrupt firms face problems in attaining financing in capital markets; but, it is the internal lack of managerial expertise in many of these firms that prevents exploration of different financing options.
  
  
• In diagnosing the root causes of small firm failure it should not be surprising that this turns out to be the management inefficiency of owner-managers. In the 1930s in the US, management deficiencies were claimed to be related to business failure by Cover (1933) who said that 'discernible errors in management' were a major cause of retail bankruptcies. Dun and Bradstreet studies have consistently found that causes due to poor management predominate in failures (Peacock 1985c): US business failures, 92% due to management, US 17,000 business failures, 94% due to management, and Canada 2,598 business failures, 96% due to management. According to national annual reports under the Bankruptcy Act, internal factors relating to the quality of management are reported as major or contributing causes of failure at least as twice as often as factors external to the firm (Williams 1986; McMahon et. al 1993). Similarly, business consultants claimed that 90% of business failures were due to management inadequacy (48% incompetence and 42% inexperience).

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