September 22, 2014

Start-up Failure Rates Vary — Choosing the Right Industry Matters

I’m following up my posting of a few weeks ago on new business failure rates where I said that there are considerable differences across industry sectors in business failure rates.

Below is Figure 7.1 (p.113) from my book Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By. The data come from an article by Amy Knaup in Monthly Labor Review and look at the 1998 cohort of new businesses.

Business failure rates by industry

(Click for larger image)

Source: Adapted from Knaup, A. 2005. Survival and longevity in business employment dynamics data. Monthly Labor Review, May: 50-56.

The data show that the four-year survival rate in the information sector is only 38 percent, but is 55 percent in the education and health services sector. That is, the average start-up in education and health sector is 50 percent more likely than the average start-up in the information sector to live four years. That’s a huge difference.

Moreover, most of the sector trajectories don’t cross; the sectors that have lower initial survival rates generally tend to continue with these lower survival rates every year.

In short, the sector of the economy in which you start your business has a huge effect on the odds that your company will still be around several years in the future.

* * * * *

About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of eight books, including Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By; Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures; Technology Strategy for Managers and Entrepreneurs; and From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company.

41 Comments ▼

Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

41 Reactions

  1. I’m a firm believer that the most important factor for sustained business success is the quality of the product and the quality of execution (i.e. the team). A smart team can enter a saturated or “bad” market with something truly outstanding and do very well.

    At the end of the day, I would never pooh-pooh a business idea just because of the field, I would look at the team and the product first.

  2. Neil,

    For the past 20 or so years, venture capitalists have put four-fifths of their money in 5 industries. Is it possible that they recognize that the odds of success are different in different industries and so put their money where they are most likely to get the best returns?

  3. Scott,

    That’s probably a very smart on their part. If I were a VC, it would be absolutely rational for me to invest according to statistical averages to get predictable returns over a bunch of companies I’m investing in. Just like investors with index funds outperform day traders.

    I guess my confusion is about the message an individual entrepreneur is supposed to take from this data. I would think most entrepreneurs enter a field because they have spotted a need that they think they can fill better than everyone else (i.e the average) in a particular field, and because it’s their passion.

    Is this a reality-check saying that, if you intend to enter a certain field, the statistical odds of success for an average company are low – so you better not quit your 9-to-5? I will concede if any would-be entrepreneur gets discouraged by that, then it’s a good thing that they are not starting a business anyway.

  4. Scott,

    Which is the safest branch / sector overall?

  5. Hi Scott,

    Knowing from your post that 55 per cent of bizzes on education and health services sector, I’m becoming more determined to enter the education sector!

    Thanks for the great info :)

  6. I love @guykawasaki comment on twitter after reading this post: “guykawasaki @strategystew I think you pick the sector you love and go for it and not worry about the stats 12 minutes ago from twhirl in reply to strategystew “

  7. Ivana,

    I’d have to ask Guy to be sure, but I’ll bet that he pays attention to the sector when he is investing money in start-ups. I’m guessing he’s invested in far fewer retail clothing stores, restaurants, and construction companies than software companies.

    It’s great to do what you love, but it’s also great to love what will help you be successful.

  8. good info but there are so many sub sectors in each of these categories thats its hard to use those stat relaible from the entreps point of view- and most entreps start with the product and then validate the market. Especially in tech – where many people fail but the rewards of success are so great – I don’t think the fact that success is limited to only the best few companies should be a deterrent.

  9. also quick question – retail seems to have a high failure rate – is there any differentiation or side stats on pure play online versus brick and mortar?

  10. Everyone is making good points here and industry matters, although, many other factors matter as well and it’s a winning combination that truly ensures success.

  11. Neal O'Sullivan

    Prof. Shane: Very interesting article. I’d be interested in knowing the strength of corelation between the negative slope (both first and second order) and the make up of the balance sheet (i.e – D/E). Does leverage play a role?

  12. Knowing how hard some industries are would color my attitude towards them.

    For instance, knowing how many hours you have to be on your feet each day in a restaurant and all the staffing headaches involved, and then knowing the chances for success are lower, I’d certainly have a hard time loving the restaurant industry … but that’s just me.

    Anita

  13. Good point about selecting an industry with high survival rates for a startup … but does not an entrepreneur have to stick to the industry he or she knows? Perhaps the information is valuable for angel investors but I think entrepreneurs cannot change their spots, stick with your strengths.

  14. Neal O'Sullivan

    Joe, you raise a very practical point. However, consider the scenario where the start-up owner is sufficiently capitalized – “out-of-the gate” and as such the brain trust is part of the balance sheet. In this scenario, you forgo the angel and utilize exogenous management oversite…- assuming of course you’ve got the belly for a fight

  15. I think having this sort of information before starting a business actually makes sense. It would be good to know and this may be in the book what are the reasons behind the failure rates within the sectors. This would provide guidance for someone wanting to start a business or a looking to invest.

  16. Interesting data that can be translated to the purchase of a franchise. But, isn’t it an error and untrue to indicate that a franchisee is in any way an entrepreneur? Even the SBA indicates that a franchisee doesn’t buy a “business of his own” and others have indicated that a franchise is a wasting asset because of the finite contract terms.

    It is the franchisor with the new “branded” concept who is the entrepreneur and the startup franchisee who provides the cheap labor and the cheap “venture” capital to grow the system sales is merely a resource of the franchisor indentured under a long-term contract.

    Professor Shane! Aren’t these long-term franchise agreements and long-term leases, generally ten years or more, that are required to purchase franchises a matter of premeditated malice in view of the startup failure rates produced by the Bureau of Census for the SBA advocacy committee? It appears that in the case of new franchisors, two-thirds of them won’t be around for ten years, and 50% or more of their startup frnchisees won’t even survive five years, etc..

    Does “churning” of startup franchisees increase the odds of survival for startup franchisors and mature franchisors? Where did the 95% success rate come from –that has become a myth used to sell franchises? Is this why federal regulatory policy supports the franchisor at the expense of naive and inexperienced prospective franchisees who have no idea of the inherent risk of the investment in the franchise –and no idea of the malicious legal trap that is set for them by way of take-it-or-leave-it co-terminus long-term franchise agreements and long-term lease agreements that are personally guaranteed?

    In your opinion, does the end justify the means?

    Thank you!

    .

  17. Carol,
    I couldn’t agree with you more! I work for a microlender and have both franchise and non-franchise clients. My role here is to review busienss plans for SBA loans and also work in a consulting capacity after the loan is granted. I also have 20 years experience in marketing (corporate) and have operated my own small business. I also have a M.S. In any event, as such, I can clearly see how franchisors often dupe even the most educated buyer. One client, a CPA, left her career to buy a massage franchise with statewide rights to sell other franchises. Give me a break. She paid $100,000 for this priviledge – one where the franshisor has NO brand equity in this state and where she assumes the sole liability and expense for her investment. She, like all small business owners, must determine the demand for her services, find propsective clients, advertise and promote and sell her services. She had to find the location for her retail site, paid $40,000 over budget for the build out, and gets little, if any support from the franchisor. Yes, she is personally liable for the cause. In Wisconsin, so is her husband since this is a joint property state. And, as you indicated, the success rate – we’ll, let’s just say I see empty store fronts for both franchise and independent business owners all over town.

  18. Thanks, Susan Taylor, for an honest response to my comments. Obviously, because the franchisors “small business” can sometimes beat the hard failure statistics of ALL small business startups, independent and franchised, government regulatory policy favors the franchisors for the purpose of stimulating the economy.
    There were CPA’a and sophisticated franchisees who were also “fooled” by the SonaMedSpa offering; they thought they were buying a proven “turn key” operation with little risk and they lost millions when their businesses failed.

    Franchisors, strangely, don’t have to disclose any historical unit performance statistics that are in their possession and don’t have to make “earnings claims” in their disclosure to the buyer. There is cooperation within the status quo to sell franchises as less risky than an independent business and the matter of known risk, as demonstrated by historical financial performance statistics of the units, is not required to be disclosed to new buyers under current regulatory policy. The average boilerplate franchise agreement for retail franchises is a malicious legasl trap that new buyers don’t discover until after they run into trouble with the franchise they have purchased, and then it is too late.

    The FTC Rule and the State FDD permits franchisors to hype and HARD SELL outside of the FDD and the actual franchise agreement and even sophisticated CPA types don’t realize that they have NOT been provided with any evidence that the franchise is successful in terms of performance statistics concerning profits or survival of other first-owners who bought the franchise. Apparently, if the risk, as known to the franchisor, had to be disclosed under the law, this would inhibit somewhat the sale of franchises to the public.

    New franchisors, apparently, don’t have to provide any kind of proforma for their pilot model and in effect, under government regulation, if they have just ONE unit of their system standing, and can meet the requirements of the FTC Rule and any State FDD, they are licensed to sell the franchise in the State at any rate of failure or success with immunity from any recourse under the law from failed or failing franchisees who were misled and promised success outside of the FDD and the contract. The government Rule and FDD acts to “legitimize” the franchise and the franchisor and lulls the buyers of franchises into a false sense of security while protecting franchisors from charges of fraud in the inducement to contract in arbtitration and the courts.

    The voluminous disclosure document acts as a red herring to divert the attention of buyers of franchises from the fact that they are given no “proof” by the SELLER as to the viability of the “proven” plan that they will purchase in terms of performance history.

    As Susan Kezios of the American Franchisee Association says, the failure of the FTC to mandate that any unit historical performance statistics be disclosed by franchisors to new buyers is misleading by omission. How can we NOT realize that this is the intent of the FTC Rule and the State FDD’s in their intent to establish regulatory policy that stimulates the economy and that serves the “greater good?”

    Apparently, since you work with SBA Loans, you understand that the SBA does make some effort to keep track of the defaults on SBA loans so as to protect lenders but the SBA, through FranData, admits (recently) that the SBA programs are not highly accurate in identifying franchise loan guarantees and franchise default rates and that the banks and lenders shouldn’t depend on them. It is my understanding that neither the SBA nor the lender routinely make the default rate of franchises loans available to those who apply for guaranteed loans, or micro loans, and this, of course, compounds the problem for franchisees. Is there any accountability built into the system?

    I think franchising grew as part of the bubble of the mortgage industry. The securitization of franchises and leases increased and was backed by the SBA and the rising equity in the homes of the middle class Americans who buy retail franchises as a means of producing jobs and income.

    Unfortunately, in the “black swan” of recessions, franchising seems to grow because the need for a job and income grows and franchises are sold as providing the opportunity to achieve the American Dream, but the actual risk is obscured. The targets now of the franchisors are the VETS and their family members who are eligible for SBA guaranteed loans under the Patriot Express Loan Initiative “pilot” program passed into law in June of 2007, obviously, with the view of preventing or easing a recession.

    Do you think franchising could survive if franchisors were mandated to disclose unit performance statistics of their systems in their possession to new buyers of their franchises? Will the risk assessment procedures of the banks and the lenders now start to do what regulation has failed to do and protect prospective buyers of franchises from purchasing high risk franchises in which they lose their entire investment?

  19. I wish people would focus on the real human cost of all these failures. Approximately, 50% of people that start a new business will lose their investment within just 4 years (what about after 10 years?). And if they put up their house for financing, they may well lose their house. And since almost all obligations of a small business require a personal guarantee, probably many will end up declaring bankruptcy. And the SBA isn’t better than any other lender. They put a lien on your house for the entire amount of the loan, even if it exceeds your equity in the house. And if you don’t pay your loan they will foreclose for the full amount due!

  20. Steve, you raise an important point. Going into debt to start a business is a risky move.

    However, my point would be this: there are many other ways to start a business without going into debt. People in developing countries do it every day.

    Sometimes you have to be willing to defer gratification. And when you do that, the victories and rewards and successes are all the sweeter. :)

    — Anita

  21. Yes, Anita, if you have cash and savings that you can afford to lose and want to buy yourself a job and a new life style, perhaps the “gamble” is worth the “return” on the investment in a small business, but a “franchise” is not a business of your own. Franchising grows in bad times because the “franchise” appears to meet the needs of the buyer for a job and the buyer is willing to borrow and invest in himself, and is led to believe through hype and advertising and PR that a franchise is a proven plan that is generally successful.

    It is, however, most often the franchisor (the entrepreneur) who realizes the victories and rewards of franchising his concept and his rewards are very sweet, especially in view of the fact that the franchisor avoids the financial risk of building and operating the units that will wear his brand name and earns his profits on the gross sales (not the profits) of his franchisees.

    Franchisors survive recessions because they don’t share in the failure of their franchisees when product demand is reduced, and they are able to sell new franchises. based on their visibility alone in American communities, out the front door and the discounted units of the failures, as well, out the back door.

    I think Steve is pointing out that franchisees who have borrowed to finance a franchised business and who sign ten-year franchise agreements and ten-year lease agreements that are personally guaranteed are just meat to eat when the 50% failure rate of startups within the first five years comes into play. Aren’t the ten-year contracts and the ten-year leases just malicious legal traps to ensure that the franchisor can acquire the assets of the failures for nothing to continue in the service of the franchisor?

    The SBA guaranteed loan is not a gift, and the SBA does put a lien on your house, and they will foreclose on your house if you can’t pay off the loan.

    The human cost of the failure of franchisees is hidden from view and this is a dirty little secret of the franchise industry. The Internet, however, will give a voice to the victims.

    Thank you, Anita, for allowing me to express my views on your Site. I know that you could block my computer from your site at any time you chose to do so. Of course, our great American enterprise system has been built on new ideas and new ventures and I am not at all against anyone who has a good idea who wants to start an independent small business, but a franchise is not a small business of one’s own. I am trying to find the authority under the law where the SBA can loan money to franchisees under the premise that they are small business “owners.”

    -Carol

  22. Be careful of making important decisions from simple analysis. It would be worth looking at the data behind these graphs in more detail, before concluding on which industry sector is worse than the other.
    What we can say is clearly some industries have greater barriers to entry than others
    (see Michael Porter’s work on determinant factors), however that is only half the story as other posters point out, things like quality of business plan, the individuals involved, the unique selling points of the business, competiive landscape, location etc…

    Questions you would need to ask of the data behind these graphs are 1) when dealing with % are the sample number of companies the same in each sector 2) Are there other determinants other than sector important here e.g. access to capital, size of start up, time of company (partnership versus Ltd company etc.)

    If I take as an example the mineral extraction industry – this is a sector typically dominated by big business, global companies that can take risks, over a long time it takes to find and prove reserves. Can you imagine a small 6 man start up surviving, but if you change the question to how would they survive then, you will find the start ups that do focus on very specific knowledge they have in very specific areas, and they demonstrate they have the best % finding of new reserves than the big boys.
    And they only specialise in the consultancy services to find the reserves and do not need then access to capital to prove the reserves.

    Final thought if everyone beleives that the education sector is the best sector to start up guess what will happen with the data overtime. Yes that is right everyone piles into education many with half baked business plans and failure rate increases dramatically. Is this perhaps a dot.com hangover that failure rate in IT is higher than the other sectors?

    Don’t choose a start up because of sector – instead look for unique advantages these companies will bring to a sector. Even in bad markets there is gold.

    My company provides training, coaching to innovative businesses and finds the talent they need to thrive if you want to know more please go to http://www.training.sparrowmc.co.uk.

  23. Choosing the right industry does help your chance of success, but there are others. I tried to extract a summary of basic principles which are critical to the succes of a startup. See my article “Startup Principles for Success” on http://blog.startupprofessionals.com for some key ones.

    Martin Zwilling, CEO & Founder, Startup Professionals, Inc.

  24. disturbed landlord

    Hello, this request is for Carol Cross. I have read your postings and I believe you may be able to show me a better direction to research our problem. We have/had a franchisee tenant in a restaurant lease, now in breach of no payment for 3 months. However, the “managing company” claims they are managing the franchisee’s affairs and that the “managing company” is not a new ownership, therefore, they are not subletting and we, the landlord can do nothing about it. the “managing company” wants to discount our rent over $3,000 a month. Our question is, can the franchise company allow a managing company to run the franchisee’s locations? one of the franchisee’s locations filled ch 11. it does not make sense? we called the franchise and all they would offer is, “we are watching the franchisee and they still have a license to sell our product at their 4 locations.” is the franchise in on the deal until the “managing company” gets their license as a franchisee? the franchise is still getting their royalties monthly but we have not been paid as a landlord for 3 months. please comment.

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  26. Not to sound cyncial, but…..do you really think it’s a good idea to look at the numbers and then conclude that correlation also means causation?

    A survival rate that’s twice as high could simply be caused by the fact that smarter people are drawn to certain industries.

    That being said, I found this blog, because I did a search for something such as “right market” and “entrepreneurs”, which I guess shows that I share your opinion – I just don’t think the stats necessarily back it up.

    Btw – what I find really interesting (being an online marketer myself), is that in online marketing & SEO, most really good people are known to stop working for other people and just run their own sites for a living (multiple sites usually).

    “Chance” seems to play a very little role when it comes to experienced SEOs/Online marketers who turn (online) entrepreneurs, but it seems to be about skill for the most part….whereas the same thing apparently cannot be said about people starting businesses offline if what Ive read is correct.

    It makes me wonder if online skill plays a much higher role (Im not saying it’s easy, obviously a bunch of people do fail online), perhaps because the cost of starting a new website, and getting it to the point where it pays for itself is so much lower of an investment (thus someone who is great at it can start multiple sites and abandon those that aren’t working out without too much of a cost).

  27. So all this stuff about success and failure is great for today’s business owner. However, I am only 17 years old and still have alot of schooling left before I can even think about walking into a bank and asking for a loan. So my question is what does the future look like for, well, future business owners? I would love to own a business and not have to live paycheck to paycheck but I want to know your opinions as to what the success/failure rates might look like in 5-10 years.

  28. I bookmarked this web address a while ago because of the new content and I have never been disappointed. Continue the outstanding work.

  29. Shane, I would love to see this graph in higher resolution. I can’t read it as is even when I clicked on it and I have a large screen. Would you mind sending that to me or reposting for everyone to see? Thank you!

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