USI: College of Business--Small business failure rates

Small business failure rates: don't believe everything you're told

By Dr. Gregory B. Murphy
taken from Evansville Business Journal, June 2007

Editor’s note: Dr. Gregory B. Murphy is associate dean and director of the MBA program for the College of Business at the University of Southern Indiana.

“Eighty percent of all new small businesses fail in their first five years.” This statistic should scare you if you’re thinking of starting a new business, especially since the majority of new businesses are financed first by personal savings and personally secured debt (a home equity loan for example) and next by the three F’s: family, friends, and fools. Assuming you want to keep your savings and friends and make an occasional appearance at family reunions, starting a small business is way too risky! Right? Not so fast. Conventional wisdom is, in this case, very misleading. Here’s why.

Historically, we are really bad at tracking small businesses. Conventional wisdom regarding small business failure rates is based on the assumption that if a small business can be identified as new in a given year and cannot be identified five years later, it’s a failure. That’s a problem.

Years ago, while working on my Ph.D. at the University of Houston, Lowell Busenitz and I (Busenitz is now at the University of Oklahoma) canvassed a number of small businesses in Montgomery County, Texas. We were checking the accuracy of some different sources that list small businesses. We were a bit surprised at the number of small businesses we were able to find that could easily have been identified as failures. This experience gave me some insights and got me thinking more about the misclassification of small businesses as failures.

Just because a small business is no longer listed in a given source doesn’t mean it is no longer there. A number of sources that list small businesses are based on compiled yellow pages. Other sources require the small business owner to pay a fee and/or provide company information to be included in their listings. So what happens if a small business is no longer listed in a source because the owner no longer wants to pay the listing fee or provide the requested information? You guessed it. If that source is being used to track the small business, it probably will be counted as a failure — even if nothing else about the business has changed.

Two other common cases merit discussion at this point. If a small business changes its name significantly, it is very likely to be counted as a failure since it will be difficult to track. Also, if a small business moves, it may not be tracked and counted as a failure as a result. Tracking small businesses is a big problem, but not the biggest problem.

‘Failure?’

Even if a small business is accurately tracked, is it fair to label a discontinued business as a “failure”? Consider the following possibilities.

If an entrepreneur successfully starts and grows a business and then sells it to another company at a nice profit, should that business be counted as a failure because it no longer exists as a separate entity? Clearly not. If a near-retirement professional starts a consulting company to cap off his or her career and does so successfully and then retires, closing the business four years later, should that business be counted as a failure? Ironically, very successful small businesses may be mistakenly labeled as failures.

If an entrepreneur has big dreams and starts a business that earns only small profits, and closes as a result of failing to live up to the owner’s expectations, should that business be listed as a failure? You decide. The point here is that when we normally think of small business “failure,” we normally assume financial distress. However, small businesses close for a variety of reasons and financial distress is only one of those reasons.

Better information

So, what percentage of new small businesses close due to financial distress? Conventional wisdom isn’t much help since that statistic includes firms that are poorly tracked and firms that close for reasons other than financial distress.

The best estimates that I am aware of indicate that approximately 30 percent to 40 percent of small businesses fail in their first five years due to financial distress (see for example research by John Watson and Jim Everett). More specifically, approximately 30 to 40 percent of new small businesses experience bankruptcy or are sold or closed to avoid further losses. By the way, small businesses actually have lower bankruptcy rates than larger businesses (they have less debt).

The point of it all

Starting a small business usually requires some degree of risk taking. However, the likelihood of financial ruin is greatly exaggerated. Perceptions of risk matter. Risk perceptions and entrepreneurial action are related. Would-be entrepreneurs who perceive unacceptable levels of risk are unlikely to start or grow new businesses.

Conventional wisdom, that 80 percent of all small businesses fail in their first five years, is very misleading and very bad for business. Let’s stop propagating this bad statistic.

Back to those businesses that are closed or sold to avoid further losses — many of those aren’t really that bad — and if you learn from your mistakes, is that really a failure?