Small Business Failure Rate Grossly Exaggerated?

Last weekend I visited a local Chinese restaurant I enjoyed as a kid.

The experience was a fun walk down memory lane. I hadn’t eaten there for decades. (Over the meal, the owner mentioned they started the restaurant 55 years ago. Wow.)

Because earlier in the day, by coincidence, I’d been reading Daniel Kahneman’s thoughts about entrepreneurship and business failure statistics, the experience prompted me to reflect on the small business failure rate. Especially the general public’s perception of the failure rate.

And my key thought? I am pretty darn sure conventional wisdom exaggerates the true risks of entrepreneurship.

But hear me out… and see if you agree.

The Conventional Wisdom about Small Business Failures

The conventional wisdom goes like this: Most small businesses fail. Twenty percent for example close in the first year. Most don’t last more than five years.

That’s the conventional wisdom…

And if you don’t believe me? Yeah, go ahead and Google on the phrase “small business failure rate.” The search results pages will link to a long list of webpages that repeat this assertion. And many of these sources? Highly credible.

Big newspapers. Popular blogs. Well-known business publications.

Small Business Failure Definition

The source for the small business failure rate varies.

But these days, writers often directly or indirectly reference the Bureau of Labor Statistic’s Business Employment Dynamics statistics study. Or the Census Bureau’s Business Dynamics Statistics database.

Those statistical studies mostly track employment by quarter and employer.

And what the studies report as a business failure? When a business stops employing people.

For example, the Bureau of Labor Statistics reports on when some business paid employees the third month of the previous quarter but paid no wages in the current quarter based on unemployment insurance claims. (Here’s an example table of data that provides this sort of information.)

The Census Bureau sort of does the same thing—only with an adjustment that doesn’t count mergers as failures if the new combined firm continues.

But to be nitpicky—and we should—these definitions arguably fail to accurately describe reality. Maybe even badly fail.

Which I found myself thinking about over the Mongolian beef lunch special.

How the Conventional Small Business Failure Definition Fails

You’ve maybe already spotted the logic error in the definition. Some employer who stops paying wages may not have failed.

If an entrepreneur sells a business for a big windfall? That may show up as a failure.

If a small business owner with a profitable operation gets an irresistible job offer and so takes the job? That may show up as a failure.

If a small business person retires—maybe after making a good living for decades? That may show up as a failure.

In all of these cases, and more as well, the employer may stop paying wages. Or the business activity may stop. And that meets the Bureau of Labor Statistics’ or the Census Bureau’s definition of failure.

However, the business owner or entrepreneur may in fact see the change in status as a success.

My blog posts sometimes get way too long. That’s probably because most of my writing? Books.

But let humor me for a few more paragraphs… because I want to share a handful of related comments.

Daniel Kahneman is a Nobel Laureate But…

A first tangential comment. Daniel Kahneman in his classic, Thinking Fast and Slow, uses entrepreneurship as a perfect example of a common flaw in our thinking: being optimistic. (He calls this an optimism bias. And in that discussion, he quotes the statistic discussed in this blog post.)

But while I love Kahneman’s book—you really want to read it if you’ve not yet done so—I respectfully submit he gets this bit about entrepreneurship wrong.

With great irony, Professor Kahneman actually makes two other cognitive mistakes he warns readers about in the chapters before the chapter where he warns people about entrepreneurship and optimism bias.

He (like many others) uses the answer to a different easier question. He doesn’t know how many entrepreneurs fail, so he looks at how many employers stop paying wages.

Further, he falls into the trap of relying on a popular easy-to-understand story—what his book calls a “narrative fallacy.” That story? Well, that we all know most small businesses fail.

We want to avoid making the same errors.

Anyway, that’s my first comment.

A little sidebar may be appropriate here: Professor Kahneman received a Nobel prize in economics for the work he an Amos Tversky did on prospect theory. I want to acknowledge that.

Ask Your CPA About Small Business Failures

Another tangential comment. If you work with a CPA, ask her or him if most of their small business clients quickly fail.

My hunch? She or he won’t say that’s the case. She or he won’t say, “Oh, heavens yes… it’s a bloodbath. Every year. I don’t know why people keep trying it…”

Rather, she or he will say, “Well, you need to be careful… thoughtful… but yeah, some folks do really well.”

Your accountant may then go on and talk about having a business plan. Maybe about needing to be adequately capitalized. And other stuff along these lines.

That commentary represents only anecdotal information of course. But it also hints that the conventional wisdom about small business failure rates may be wrong.

A Last Comment About Small Business Failure Rates

And this final comment about small business failure rates.

Not much data exists about the number of business closures that count as clear-cut entrepreneurial failures.

But some does. And the picture that data paints looks very different from the conventional wisdom.

As one example, Australian business school professors Jim Everett and John Watson looked closely at failures of mall-based retailers about two decades ago in a paper entitled Small Business Failure and External Risk Factors.

What they found? Nearly half the closures were voluntary. So, not economic. Rather, business owners closed stores due to retirement, health reasons, or simply to exit at a profit.

Those researchers were careful to say their small study shouldn’t be generalized. But one can’t ignore their data. If Everett and Watson were right, maybe half the failures the popular statistical studies report should be reclassified as entrepreneurial successes.

Which changes the situation a lot…

Other Resources

The Bureau of Labor Statistics entrepreneur information including the Business Employment Dynamics survey appears here.

The Census Bureau’s Business Dynamics Statistics overview appears here.

A few years ago, we blogged about the odds of entrepreneurial success and shared some real-life anecdotes. If you’re thinking about whether or not you want to become self-employed, that discussion may be useful.

Finally, we rebut some of the academic arguments against entrepreneurship here: The Illusions of Entrepreneurship Professors.