What Causes Small Businesses to Fail?

The short answer is, regardless of the industry, failure is the result of either the lack of
management skills or lack of proper capitalization or both.

Eleven Common Causes of Failure

Choosing a business that isn't very profitable. Even though you generate lots of
activity, the profits never materialize to the extent necessary to sustain an on-going
company.
Inadequate cash reserves. If you don't have enough cash to carry you through the first
six months or so before the business starts making money, your prospects for Success are
not good. Consider both business and personal living expenses when determining how
much cash you will need.
Failure to clearly define and understand your market, your customers, and your
customers' buying habits. Who are your customers? You should be able to clearly
identify them in one or two sentences. How are you going to reach them? Is your product
or service seasonal? What will you do in the off-season? How loyal are your potential
customers to their current supplier? Do customers keep coming back or do they just
purchase from you one time? Does it take a long time to close a sale or are your
customers more driven by impulse buying?
Failure to price your product or service correctly. You must clearly define your
pricing strategy. You can be the cheapest or you can be the best, but if you try to do both,
you'll fail.
Failure to adequately anticipate cash flow. When you are just starting out, suppliers
require quick payment for inventory (sometimes even COD). If you sell your products on
credit, the time between making the sale and getting paid can be months. This two-way
tug at your cash can pull you down if you fail to plan for it.
Failure to anticipate or react to competition, technology, or other changes in the
marketplace. It is dangerous to assume that what you have done in the past will always
work. Challenge the factors that led to your Success. Do you still do things the same way
despite new market demands and changing times? What is your competition doing
differently? What new technology is available? Be open to new ideas. Experiment. Those
who fail to do this end up becoming pawns to those who do.
Overgeneralization. Trying to do everything for everyone is a sure road to ruin.
Spreading yourself too thin diminishes quality. The market pays excellent rewards for
excellent results, average rewards for average results, and below average rewards for
below average results.

Overdependence on a single customer. At first, it looks great. But then you realize you
are at their mercy. Whenever you have one customer so big that losing them would mean
closing up shop, watch out. Having a large base of small customers is much preferred.
Uncontrolled growth. Slow and steady wins every time. Dependable, predictable growth
is vastly superior to spurts and jumps in volume. It's hard to believe that too much
business can destroy you, but the textbooks are full of case studies. Going after all the
business you can get drains your cash and actually reduces overall profitability. You may
incur significant up-front costs to finance large inventories to meet new customer
demand. Don't leverage yourself so far that if the economy stumbles, you'll be unable to
pay back your loans. When you go after it all, you usually become less selective about
customers and products, both of which drain profits from your company.
Believing you can do everything yourself. One of the biggest challenges for
entrepreneurs is to let go. Let go of the attitude that you must have hands-on control of all
aspects of your business. Let go of the belief that only you can make decisions.
Concentrate on the most important problems or issues facing your company. Let others
help you out. Give your people responsibility and authority.
Putting up with inadequate management. A common problem faced by Successful
companies is growing beyond management resources or skills. As the company grows,
you may surpass certain individuals' ability to manage and plan. If a change becomes
necessary, don't lower your standards just to fill vacant positions or to accommodate
someone within your organization. Decide on the skills necessary for the position and
insist the individual has them.
So, the founder's attitude, ability to be objective, willingness to bring in needed help,
and share power are all crucial to success. "Most startups make the mistake of falling
in love with their product or service," says Shukla. "Ultimately, it is this lack of selfcriticism that causes many companies, startups and their more mature counterparts, to
fail. Startups suffer this fate more often because there are more dreamers than doers."
I think that fact speaks for itself," says Jonathan Goldhill, a small-business consultant and
former director of an economic development center in California's San Fernando
Valley. "I would say that the primary reason for failure of startups within three
years is usually...management's failure to act, or management's failure to react, or
management's failure to plan."
Other reasons why businesses fail in their early years include: poor business location,
poor customer service, unqualified/untrained employees, fraud, lack of a proper business
plan, and failure to seek outside professional advice.
While poor management is cited most frequently as the reason businesses fail,
inadequate or ill-timed financing is a close second. Whether you're starting a business
or expanding one, sufficient ready capital is essential. It is not, however, enough to
simply have sufficient financing; knowledge and planning are required to manage it well.

These qualities ensure that entrepreneurs avoid common mistakes like securing the wrong
type of financing, miscalculating the amount required, or underestimating the cost of
borrowing money.

Top Ten Legal Mistakes Made by Entrepreneurs

10. Failing to incorporate early enough. One problem that arises here is the so-called
"forgotten founder": a partner involved in starting the venture subsequently drops out.
When the venture gets financing or is ready to go public, this partner returns, perhaps
with an inflated view of what his or her contribution was, demanding equity. This
problem can be eliminated by incorporating early and issuing shares to the founders,
subject to vesting. As partial consideration for their shares, each founder should be
required to assign to the new corporation all inventions and works related to the
company's proposed business.
Incorporating early, before significant value has been created and well in advance of any
financing event that establishes an implicit value for the shares - also helps prevent
potential tax problems for "cheap stock." Incorporating too late, and issuing inexpensive
stock to the founders at the same time that much more expensive stock is being sold to
investors, can create tax problems when the IRS argues that the difference in stock price
is actually income to the entrepreneur.
9. Issuing founder shares without vesting. Simply put, vesting protects the members of
the founding team who take the venture forward. If people remain on the team and are
productive, their shares will vest. If they leave earlier, that stock can be retrieved and
given to whoever is brought in to replace them.
8. Hiring a lawyer not experienced in dealing with entrepreneurs and venture capitalists.
Many venture capitalists say that they often rate the judgment of entrepreneurs by their
choice of legal counsel. Lawyers who have no experience working with entrepreneurs
and venture capitalists will most likely focus on the wrong things while failing to
recognize some of the more subtle potential traps. It's better to hire someone who has
played the game, who knows what's standard and what isn't, and who will get the deal
negotiated and closed promptly.
7. Failing to make a timely Section 83 (b) election. If the advice in 9 is followed, then
shares will be issued, subject to vesting, to the founders as well as new employees. If
stock is acquired and it's subject to what the IRS calls a substantial risk of forfeiture, then
the IRS doesn't view the purchase as being closed until that risk goes away. When the
stock vests, that risk evaporates, so the IRS considers the deal closed. The IRS then
calculates the difference between the price paid at the outset and the fair market value at
that later date, then taxes this difference as ordinary income. An 83 (b) election allows the
tax computation to be made based on the value at the time the shares are issued, which is
often pennies per share.

6. Negotiating venture capital financing based solely on the valuation. Valuation is not the
only thing one should consider when selecting a venture capitalist or when negotiating
the deal. There are many other ways for venture capitalists to get compensated if they end
up paying a high price for shares. These include requiring participating preferred with a
high cumulative dividend, redemption rights exercisable after only several years, and
ratchet anti-dilution protection with no cap.
One must ask, what's the reputation of this firm? Do they have a history of standing by
the entrepreneur if the entrepreneur stumbles? Do they have good contacts in the
industry? In trying to build alliances, do they know the big players? A no-name firm
offering the highest valuation is often not the best source of equity.
5. Waiting to consider international intellectual property protection. Patents are granted
on a country-by-country basis (with a single application available for the European
Union). In the United States, if an invention is sold or made public, there's a year's grace
period to file a patent application. Everywhere else, if the invention is sold or publicized
prior to filing the patent application, the invention is unpatentable in that country. For
example, if the invention is publicly disclosed to a Japanese national visiting a tradeshow
in the United States, then under Japanese patent law, if no patent application has been
filed, that disclosure makes the invention unpatentable in Japan. The same is true with
trademarks. A tremendous amount of money might be spent in developing a brand in the
United States, yet when the product is shipped overseas it could violate trademarks of
companies dealing in similar goods outside the United States. One must make intelligent
choices of where they think their markets are, and how much money to spend at an early
stage in order to insure that the brand is available in those markets.
4. Disclosing inventions without a nondisclosure agreement, or before the patent
application is filed. If patent protection hasn't been obtained, or in cases where a patent is
not available, the only protection is to maintain something as a trade secret. To do so, one
must show that they've taken reasonable steps to keep it secret from competitors.
Is it wise to get potential venture capitalists to sign a nondisclosure agreement? In the
best of all worlds, yes, but most won't. Before disclosing to anyone, one must learn who
has a reputation for integrity in the industry. In dealing with most people, it's wise to
require them to sign nondisclosure agreements. It needn't be elaborate, but it should say
that they acknowledge they may be exposed to trade secrets, and they agree not to use or
disclose them without permission. Business plans should expressly state on the cover
page that they are confidential and proprietary. That's not as strong as a nondisclosure
agreement, but laws in some states suggest that if a person knows they have been exposed
to a trade secret, they can't use it or disclose it without permission from the owner.
3. Starting a business while employed by a potential competitor, or hiring employees
without first checking their agreements with the current employer and their knowledge of
trade secrets. The law is clear that if someone is currently working for a company,
particularly if her or she is a key employee, they cannot operate a competing business.
Even just incorporating may spark a lawsuit from the current employer. Would-be

entrepreneurs should first go to their current employer and either resign or tell them what
they're doing and ask them if they'd be interested in investing. Amazingly, that's often a
very smooth way of ending that relationship. Under no circumstances should they
misrepresent the nature of the new business.
Even after leaving the current employer, one still cannot use or disclose the company's
trade secrets. Under the so-called inevitable disclosure doctrine, if someone has been
exposed to trade secrets at their job and leaves to work for someone else, and if their
responsibilities in the new job are sufficiently similar, some courts will conclude that it's
inevitable that they will use the information that they had from the earlier position. They
could face an injunction prohibiting them from working for the new employer until a
number of months go by and whatever trade secrets they had are stale.
It also helps to know whether potential recruits are subject to covenants not to compete.
States vary in terms of how enforceable they are, but one shouldn't assume they are not.
One should also check to see what assignments of inventions might have been signed.
Personnel files should be reviewed, and recruits should check theirs, to be certain that a
covenant not to compete or an assignment of inventions wasn't tucked into a signed nondisclosure agreement.
2. Promising more in the business plan than can be delivered and failing to comply with
state and federal securities laws.
If someone promises to do something and knows that they can't perform that promise,
that's considered fraud. In a business plan, one must make an honest appraisal of what's
doable and set forth their assumptions, so the person putting up money can judge whether
they are realistic. Can entrepreneurs be sued by their funders for fraud? Yes. Trying to
squeeze out a little extra valuation by fudging the numbers erodes credibility, makes
investors less trusting, and ultimately impairs the ability to get subsequent rounds of
financing.
Finally, anyone selling stock or other securities must comply with both the federal and
state securities laws by either registering the securities (rare for a start-up) or meeting all
the requirements for an applicable exemption. Ignorance of the law is no excuse. As one
judge put it in a decision upholding criminal convictions for violating the securities laws:
"No one with half a brain can offer 'an opportunity to invest in our company' without
knowing that there is a regulatory jungle out there."
1. Thinking any legal problems can be solved later.
There's a tendency to think, "Once I get my funding, once I'm up and running, then I've
got time to hire the lawyers; right now, I'm running as fast as I can to get my business
plan done and raising money." This is shortsighted logic. Many of the points made here
are problems that can't just be patched up later. Does that mean that one should devote all
of their time, effort, and money to the legal issues? No. That's a good reason to hire a
competent lawyer. Excellent legal talent can be retained for relatively little money up

front at the early stages. It will cost much less to get it right at the beginning than to try to
sort it all out later and correct it.

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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Copyright 2015 Moya K. Mason, All Rights Reserved

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