If you start a business, odds are that your company will fail. Data from the U.S. Small Business Administration shows that regardless of the year when they are founded, the majority of start-ups go out of business within five years, and two-thirds are no longer operating ten years after being formed.
I bring up this unfortunate statistic to discuss a topic that all entrepreneurs should consider. Why do most start-ups fail?
A lot has been written on this question, suggesting that maybe I don’t need to write about it too. But a recent article by Jay Goltz, got me thinking that some authors try to put too much of a positive spin on the causes of business failure. In his article, Jay wrote that “out-of-control growth” is one of the top ten reasons for small business failure.
Unfortunately, this argument doesn’t jive with the data. Not enough start-ups grow for too-rapid-growth to account for the failure of more than a handful of them. A study by Brian Headd and Bruce Kirchhoff found that only 28 percent of businesses with employees have any employment growth from one year to the next. And a paper written for the Small Business Administration (SBA) by Zoltan Acs and colleagues shows that only about 6 percent of U.S. companies have sales that at least double within four years – a minimum threshold for what might be called “rapid growth.”
4 Reasons Startups Fail
If you want to know the real reasons startups fail, academic research suggests some more basic – and less flattering – reasons why so many start-ups fail.
Choosing Unfavorable Industries
Failure rates are high because a large number of inexperienced entrepreneurs start businesses that shouldn’t be founded in industries that are unfavorable to new companies.
While my statement is harsh, the data supports it. Most entrepreneurs pick unfavorable industries because they are attracted by low entry barriers. Census data show that the rate at which entrepreneurs start businesses in different industries correlates 0.77 with the rate at which businesses fail in those industries. That is, entrepreneurs favor the very industries in which businesses are most likely to go under.
No Competitive Advantage
Many entrepreneurs start companies that stand little chance of out-competing other businesses. Data from the Panel Study of Entrepreneurial Dynamics reveals that nearly 40 percent of the founders of new companies don’t think that their businesses have a competitive advantage. (Because entrepreneurs are an optimistic lot, if a business’s founders don’t think the company has a competitive advantage, what are the odds that it does?)
Lack of Industry Experience
Not enough entrepreneurs have experience in the industries in which they are starting their businesses. Academic research shows that working in an industry for several years before starting a business enhances the survival prospects of start-up. Yet, a sizable fraction of entrepreneurs start businesses in industries in which they have no work experience.
Not Adopting Good Business Practices
Many entrepreneurs fail to take the actions that research shows help businesses to survive.
Academic evidence shows that putting in place careful financial controls, emphasizing marketing plans and writing a business plan increase the odds that a new business will survive, yet many founders fail to write plans, have inadequate financial controls and don’t focus on their marketing plans.
True, some start-ups fail because of factors beyond their founders’ control. But responsibility for much of the high failure rate of new businesses lies with the entrepreneurs themselves.
Image: Small Business Trends
Thanks for this post, Scott.
I can’t believe that someone would suggest that too-rapid growth would be a common reason for small business start-up failure.
You wrote that, “Failure rates are high because a large number of inexperienced entrepreneurs start businesses that shouldn’t be founded in industries that are unfavorable to new companies.”
Right on the money.
The Franchise King®
Some businesses once they have a successful business model try to expand too fast and simply do not have enough working capital to support their growth.
Also the core business may have been successful, but further expansion into new products and markets does not prove as successful. One success does not guarantee continued success and hence the need to pilot test new products and markets rather than a leap of faith.
+1 Many failed businesses teach painful lessons. We like to hope that it will lead to a more successful next attempt, but not everyone is cut out to be an entrepreneur. Natural selection at it’s best.
Scott, a real good article. Most start-ups have no competitive advantage and haven’t thought through what would differentiate them from the competition.
This resonated, as my husband has a startup and just finished The Founder Institute. I imagine there might be stats on startups vs small businesses failing, which I’d imagine the former to be higher. Startups are rockets on a short trajectory. They’re either going to explode into high growth through a sale or acquisition, or they’re going to die. They’re short lived in that form. But the work is intense for that short period, so I’d throw stress in the ring as a factor for failure too.
Mont F. Cessna
Great article. Your next to the last paragragh says it all: no business plan, no understanding of financials and no marketing plan doom most start-ups.
Lionel Bachmann @ Model Trains
These are some really interesting stats. I will agree, start ups aren’t in their field of expertise. But is it a major factor in failure? I’m not sure I agree. The majority of working people aren’t working in fields they studied in school.
Good article, a lot of young entrepreneurs start up small businesses before really investing the time to get a solid experience in that industry. It is vital to have experience to have a great competitive edge.
I am a business owner and have been in the landscape industry for 10 years prior to opening a landscape supply center 3 years ago. Our business has began to flounder and I have said for the past year that the reason for this was because the business grew too quickly and we did not have enough capital going in with the rapid growth we have experienced. So many people would think that the rapid growth is excellent as we did over the first 2 years however it has hit us hard this year due to the lack of working capital. In this conversation with bankers and others they look at me like I am crazy, so thank you for sharing something that has made me think I was crazy and just making up excuses for why our business is where it is.
Also, some businesses go under simply because their competitive business advantage becomes sucessfully challenged and beaten by more competent business ventures,e.g. Wallmart
Starting a company is never easy, other than what you mentioned about having no experience in the industry, there’s another thing entrepreneurs usually forget. They create some impressive financial forecasts, but fail to create a “the worse scenario”. That is a plan b in case some time goes by and there are no sales. Not only money is needed to back up operations, but motivation and confidence in the project.
Presti and Naegele
As you suggested, Scott, the lack of a market for the product/service, around which an entrepreneur intends to build a business, is a major factor in the failure of start-ups. And this could be tested before throwing everything into the business.
Additionally, as Jay mentioned in his article, cost control is again a main issue, which might be prevented by having a solid business plan with realistic costs. Plus, the lack of a financial vision, once you started your company can lead to a failure.