Why Small Businesses Fail

Why Small Businesses Fail

Reasons Why Small Businesses Fail in the Post-COVID Era

In numerous countries, 2021 will be a year of exceptional economic growth. Not a surprise — it partially offsets the tragic numbers of 2020. Some nations, like Sweden or the United Kingdom, returned to the Pre-Covid levels already in the first semester. Below I list 3 major reasons why small businesses fail in the post-Covid era.

(Remember however that also large businesses may fail terribly. One example is Nokia’s failure.)

The recovery creates unusual situations. Places like the US state of Minnesota are experiencing a labor shortage that led authorities and employers to declare they are in dire need of workers.

What explains, partially, the absence of people willing to apply to new jobs is the entrepreneurial boom. A considerable share of unemployed started their own business, or are planning to.

As reported by Experian and the U.S. Census, during the last year business starts soared 27 percent to 4.4 million in the US alone. 

How many of these new firms will survive to their second year? How many will still be open in 2025?

During ordinary, non-pandemic times, these are the small business survival rates(data from the U.S. Bureau of Labor Statistics):

  • 21.6% of small businesses collapse within the first year
  • 31% of small businesses collapse within 2 years
  • 49.3% of small businesses collapse within 5 years.
  • 66.3% of small businesses collapse within 10 years.

Ps: Here are some additional business survival strategies.

The Federation of Small Businesses from the United Kingdom estimates that a quarter of a million small businesses could disappear in 2021 in the UK alone. The same alert is valid for any economy that was hit by the Covid crisis in 2021 — meaning nearly the entire world.

If you are thinking about taking the entrepreneurial road, you have my admiration— and, as Nassim Nicholas Taleb once wrote, fallen entrepreneurs deserve almost as much respect as fallen soldiers. Most of the jobs are created by small businesses, and entrepreneurs are the risk-takers that catalyze the economy.

The business traps listed below are more active than ever in 2021. If you are an entrepreneur or are planning to start a firm this year, pay close attention to them. I would like to see your firm alive and well in 2025.

All the Hows of a First-Time Business Owner: There is a thin line between bankruptcy and the freedom to be an entrepreneur: An idea for a present for yourself (or to any entrepreneur).
An idea of a present for yourself (or to any entrepreneur).

Over-Optimism Leading to Poor Credit Arrangements

This is the first item on the list of why small businesses fail because it is also the first I made as an entrepreneur.

Years ago, I took a loan to expand my business. It had an interest rate of 6%, which I considered ok since my business plan forecasted an ROI (Return of Investment) of 8% per year. 

The problem is that the sector of my first company (hospitality) has an average ROI of 4%. I expected to double the industry return. All that as a beginner. That was a very optimistic expectation.

To make things worse, the COVID crisis came. The 6% interest rate that I considered adequate became higher than our ROI. The loan turned out to be a poor credit arrangement.

With the 2021 economic recovery, other entrepreneurs may risk the same path. Here is my alert: do not take credit considering your best-case scenario. Instead, consider the worst-case, and if your ROI is still larger than the interest rate, then, and only then, you take the loan. 

As an alternative to bank loans, consider capitalization rounds. I made one 3 years ago — also thanks to the Talebian concept of Antifragility — and it reduced my risks compared to a loan. You will need to give periodic explanations to your partners about the business situation but this is little effort for the benefit of not paying dividends if you don’t profit — while banks will demand loan payment no matter your situation.

Another alternative I used to raise capital was crowdfunding, which is a good choice during uncertain times.

Book suggestion: All the Hows of a First-Time Business Owner: There is a thin line between bankruptcy and the freedom to be an entrepreneur

Picture to illustrate Why Small Businesses Fail
Why Small Businesses Fail

It is worse in the events, concert, and tourism industry

Banks work to maximize their return while reducing their risks — that is how every business should act.

To reduce risks, they tightened the credit criteria to the most affected sectors. This led to absurd requirements, like financial institutions demanding hotels to sell assets if they want to get credit.

Let’s think about this for a moment: a hotel chain is taking credit to survive but is forced to sell assets that, in an event of recovery, will make the income to pay the credit. That increases the risk that they will not make enough to pay their obligations.

It is the closest to financial suicide that someone can get.

Over-Optimism Leading to Over Hiring or Over Investment

When you have a once-in-a-century pandemic, planning gets hard. For years I worked at airline headquarters with demand forecasting. There, we worked with a concept called SE (Special Events) adjustments. 

To put it straight, it means that disruptive events, like the 2010 Eyjafjallajökull eruption, make your local forecasts useless or even harmful. The 2020 Pandemic was the mother of all special events. Instead of local, it made global forecasts useless.

Without forecasting, planning is complicated. Jason Lee, owner of Healthy Framework, in an interview for Entrepreneur.com, stated 

COVID is making forward planning near impossible. Without knowing how long it’s going to be here and to what degree, it’s nearly impossible to plan out marketing efforts, gauge staffing needs, or just know what our customers and clients need.

Planning mistakes can affect multiple areas. But none of them have the side-effects of staffing mistakes. When a firm over-hire, either they need to bear higher costs for undetermined periods, or they need to let people go. The first damages the bottom line, the second, the team morale.

When hiring, do not hire optimistically, but realistically. More employees than necessary result in idle talents, a slower work environment, and a lack of challenges and motivation. Failures that answer the question of why small businesses fail.

To help you, we wrote an article with strategic questions to ask candidates during job interviews for your business.

Growing Too Fast While Ignoring Marginal Costs

There is an episode of the comedy The Office where Michael Scott, the main character and paper company manager, decides to open his own firm and compete with his former employer.

At first, the Michael Scott Paper Company is an apparent success. Sales are growing so fast that he needs to make his team work extra hours — poor Ryan and Pam. But what Michael had as a sales genius, he lacked in finance. Days later, they discovered they had funds enough to survive only a week more. 

They were selling at a loss. With the sales expansion, their marginal costs skyrocketed, unnoticed.

This is the mystery of unhealthy growth that answers why small businesses fail.

Often founders and managers confuse success with rapid expansion. Nobody wants to limit growth, but everyone wants — or at least should — to limit cost increase. If your sales increased to the point that to deliver it, you need to pay extra hours or hire pricey services, it is time to go to the old, boring excel and do the numbers.

Do you have cash flow enough to make these investments? Is the price of your product enough to cover it at a profit? 

An alternative is to leverage price instead of production. Instead of selling more at the same price, sell the same at a higher price. This is one of the tools I learned working at the Revenue Management departments in global airlines. Airlines cannot easily create more seats in their planes — it would be too expensive or unpractical. So they leverage their prices.

Entrepreneurs often win the race against the competition by going slow and steady. The increase in marginal costs is one of the alarming signs that you are growing too quickly. Others are staff burnout, quality decline, delivery delays, etc.

Conclusion on why small businesses fail

Nearly All Problems Are Caused by Insufficient Cash Flow

It is a well-known error from aspiring entrepreneurs (here are some books recommended to them) to underestimate the funds they need — an error that I also committed once. 

If you are planning your first business, in a new industry (like I was 5 years ago), maybe cash flow is still a mystery in that sector. There is an enormous chance that you will miscalculate the money needed to take your plans from paper, and the time necessary to recover it. Fortunately, in my case, I found a local ally that warned me of these mistakes.

Business often takes longer than expected to deliver their full results. This time gap is one of the reasons nearly 1/3 of the companies collapse before their second anniversary. When calculating your finances, consider the worst-case scenario for at least the first two years to plan how much money you will need.

Sales need time to pick up, and until there, you need cash flow to survive.

Because cash flow is for a business what water is for an aquarium. If you have a hole that leaks it out, you need to discover it and tamper it quickly, otherwise, it will go dry. 

An aquarium without water means death to your goldfish. A business without cash flow is death to your entrepreneurial dreams — until you start again.

The three traps listed in this article either are causes or results from cash flow problems.

  • Over-optimism Leading to Poor Credit Arrangements. It happens when someone wants to invest but does not have the resources to do so neither the arguments to raise cheaper capital without using banks.
  • Over-optimism Leading to Over Hiring or Over Investment. A trap that results in layoffs or assets returned when the excess staff or machinery remains idle, and the cash to sustain them is not enough.
  • Growing too fast while ignoring Marginal Costs. A sped-up expansion can quickly increase marginal costs of production or marginal costs of sale, to where companies are trapped between not delivering their services/products or forced to take loans to honor contracts.

Selection of related articles to why small businesses fail:

Employer Attractiveness: Turn Your Small Business into a Talent Magnet

4 Industries and Jobs That Will Disappear Due to Technology

Levi Borba is CEO of expatriateconsultancy.com, creator of the channel Small Business Hacks, and best-selling author. You can check his books here, his other articles here, or his Linkedin here.

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