Understanding how and why businesses fail can prepare you for success.
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5 min read
The opinions expressed by the entrepreneur's contributors are their own.
Have you heard that 90 percent of new businesses fail? Or that 50 percent of new business fails? Stay in the business community long enough and you will likely hear a wide range of claims, mostly between these two extremes.
But what is the real failure rate of small businesses? And should it influence your decisions as an entrepreneur?
What we know about the failure rate of small businesses
According to the Bureau of Labor Statistics, as reported by Fundera, approximately 20 percent of small businesses fail within the first year. By the end of the second year, 30 percent of companies will have failed. By the end of the fifth year, about half will have failed. And by the end of the decade, only 30 percent of the companies will be left – a failure rate of 70 percent.
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Of course we have to accept some limitations in this data. Here are some common variables.
Definition of the fault. This study is based on a fixed number of reported companies. If a company ceases to exist a year later, it is rated as a "failure". However, there may well be valid reasons that the business no longer exists. For example, the owner might be keen to retire and decide to close the business instead of trying to sell it or change hands. It's hardly fair to view this as a failure of business. Annual deviation. As would be expected, there are differences from year to year due to economic conditions. The above data applies to companies that were examined between 2007 and 2017. It appears that many of these percentages remain relatively consistent. The failure rate might be between 15 and 25 percent for a single year, but it is unlikely to increase or decrease. There are a few exceptions that bring us to our next point. Older events. Major outlier events can significantly improve the failure rate for organizations, for better or for worse. For example, the Covid-19 pandemic has created difficult economic conditions for many industries including bars, restaurants, nightclubs, and other niches that depend on close physical interaction. Failure rates are exceptionally high for 2020, although we don't have all the numbers yet. Industry variance. Not surprisingly, the failure rate varies significantly from industry to industry. Healthcare companies and organizations tend to have a below-average failure rate because the demand for health services is high, constant and steady. At the other end of the spectrum, failure rates are high for storage and transportation companies. this is probably due to high start-up costs and a competitive market. In the middle are companies like SEO firms and other marketing firms; They offer low startup costs, but demand may vary due to market conditions or strong competition. We must also beware of reporting errors. Some small businesses may not be included in these metrics because they work in secret or because they are office workers. Other companies can be counted but may not function like typical companies. Businesses can survive even if their performance is sub-optimal. Many of the “successful” companies featured in this report may be hanging by a thread.
Why the failure rate matters
Some people use small business error statistics as a discouraging tool. You want to warn budding entrepreneurs about the dangers of starting a business. However, there is a more useful way to study and learn from statistics like this one.
For starters, failure rate gives you an idea of how and when businesses are prone to failure. Only 20 percent fail within the first year, but 50 percent fail within the first five years. In other words, another 30 percent of businesses will fail between Years 2 and 5, which is about 7.5 percent of the original amount per year. If we assume some kind of "death from natural causes" and consider that 7.5 percent figure as a predictable failure rate, we can assume that about 12.5 percent of businesses in the first year are due to a lack of preparation one way or another fail. If you're better prepared than the bottom eighth of business owners, you're in good shape.
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This is also useful for calculating the risk, especially when applying that risk to your personal life. Because of the superconsciousness effect, we tend to be optimistic about our own efforts, but statistics can keep us realistic and pragmatic. If we assume a 20 percent failure probability for our business in the first year, we should distribute our investments and our time accordingly. We need to balance our risk profile to protect ourselves in the event of a failure.
Why people overestimate the failure rate
I also want to acknowledge that error statistics are usually inflated when misrepresented. In other words, people tend to exaggerate the failure rate of small businesses. Why? This could be a conservative way of lowering expectations, or it could affect the desire to discourage potential entrepreneurs. In any case, we must be careful of people who confidently assert a trivial "truth" about corporate ownership.
Small businesses fail pretty often, to the point where you basically have a 50/50 chance of surviving year 5. However, it's important to build statistics on what they are, understand their context, and not let them unfairly prevent you from tracking your business development.