There are a lot of false statistics floating around the web about the dismal survival rates of small businesses. In this article, we get to the bottom of these stats and uncover the truth about small business failure rates.
Various Small Business Failure Rates Online
Here are some business failure rates that can be found online:
- 80% of entrepreneurs starting a business fail within the first 18 months. (Forbes)
- 50% of startups fail after operating for four years. (Statistic Brain)
- 66% of small businesses will fail within 10 years. (Tutsplus)
- 50% of small businesses fail after five years. (Small Business Trends)
- 3 out of 10 new companies “fail to survive” for more than 24 months. (Wasp Barcode)
- Only 33% percent of startups reach their 10 year anniversary. (Credit Donkey)
- Only 1 out of 5 new businesses survive past their first year of operation. (USA Today)
- Fewer than 50% of businesses survive more than 5 years. (Fundivo)
As you can see, there are lots of different statistics out there, some of which contradict each other. Many of these stats aren’t backed by studies or data. Even studies that are backed by data may not give us an accurate picture of small business failure rates.
Why All These Stats Are Wrong
In this article, we look at three statistical models of business failure rates and explain why they are inaccurate.
We chose to analyze business failure rates compiled by (1) the Bureau of Labor Statistics, (2) Harvard Business School, and (3) Economists at the Small Business Administration (SBA). We chose these three examples because they come from highly authoritative sources and expose the range of problems associated with predicting business failure rates.
Here is a snapshot of the problems with each study, followed by an in-depth explanation.
- Bureau of Labor Statistics report – This quarterly report finds that approximately 44 percent of businesses fail after 5 years. The problem with this report is that it excludes sole proprietorships, which make up almost three quarters of American businesses.
- Harvard Business School study – This study found that 75 % of venture capital-backed startups don’t return cash to investors, and that 30 % of those businesses have to liquidate all their assets. The problem with this study is that it only looks at failure rates among venture capital-backed startups, which represent fewer than 1 percent of all businesses. Failure rates among ordinary businesses may differ significantly.
- SBA Economists study – This study, which builds upon data collected by the US Census Bureau, found that 33 % of business owners considered their businesses to be failures 4 years after they exited the market. The problem with this study is that it relies on business owners’ subjective interpretations of whether their business was successful or not.
Let’s look at the three studies in detail.
Study # 1: Bureau of Labor Statistics Data
The US Bureau of Labor Statistics publishes business survival rates every quarter in its Business Employment Dynamics (BED) report (it was last updated in April 2016). The BED tracks business openings, expansions, closures, and contractions for businesses in the United States that have employees.
The BED’s most recent report found that approximately 56 percent businesses survive after 5 years. Framed as a failure rate, that means that 44 percent fail within 5 years.
The BED measures business survival by tracking business openings and expansions, and it measures failure by tracking closures and contractions.
Openings, expansions, closures, and contractions are defined based on company-reported employment changes:
- Openings – Establishments with positive third month employment for the first time in the current quarter or with positive third month employment in the current quarter following zero employment in the previous quarter.
- Expansions – Establishments with positive employment in the third month in both the previous and current quarters, with a net increase in employment over this period.
- Closings – Establishments with positive third month employment in the previous quarter, with no positive employment reported in the current quarter, or with positive third month employment in the previous quarter followed by zero employment in the current quarter.
- Contractions – Establishments with positive employment in the third month in both the previous and current quarters, with a net decrease in employment over this period.
In a nutshell, a business is born on the day its first employee registers. A business dies when the establishment reports zero employees. Sole proprietorships (e.g. one-person businesses) are not included in the data.
Why The Bureau of Labor Statistics Data Is Wrong
The fundamental problem with the BED data is its methodology. Evaluating business success and failure based on employment numbers poses two main issues:
- Sole proprietorships are excluded – Sole proprietorships, which by definition, don’t have employees, aren’t included in the BED data set. Over 70 percent of US businesses are sole proprietorships, so excluding them leaves a big hole in the BED data.
- Reducing employment levels may not indicate failure – The other problem is that reducing employment doesn’t mean a business is dying. For instance, a business owner may decide to let go of employees and hire contractors to save on overhead costs. That business could be raking in large profits, but would be considered dead in the BED report.
Similarly, small business owner may have closed her shop because she decided to retire. This exit would be tallied as a ‘closing’ under the BED data. Ultimately, the BED only provides data on employment changes and cannot identify whether a business was successful or not.
Study # 2: Harvard Study Of Venture-Backed Firms
A team from Harvard Business School looked at a specific segment of businesses to calculate failure rates: venture capital (VC) backed startups. This study, published in 2012, calculates failure rates for 2,000 venture-backed startups that raised at least $1 million from 2004 to 2010. The results show that 75 percent of VC-backed firms never return cash to investors, and 30 percent of those businesses implode, liquidating assets where investors lose all of their money. Let’s do the math to calculate the business failure rate:
- Companies that fail to generate a ROI after 6 years: 75% of 2,000 = 1,500
- Businesses that implode: 30% of 1500 = 450
- Business failure rate = 22.5% (450 ÷ 2000)
This study found that 22.5 percent of VC-backed startups fail after six years of operation if you define failure as a liquidation of all assets. This number is half as low as the BED stat. If, however, you consider a business a failure if it didn’t give an ROI to investors, then the failure rate is 75 percent.
A business that’s simply not profitable isn’t considered a failure under the Harvard study. While the company may not be generating profits now, it has every opportunity to turn the corner and achieve its goal. The company is only a failure if it doesn’t return any cash to investors or if it has to liquidate all assets.
A company acquired by a competitor or a larger company is also not regarded as a failure. While the company lost its assets, investors would have been fairly compensated. Even if the business was struggling and assets were bought below market value, investors would have recovered a portion of money invested.
Why The Harvard Study Is Wrong
The main problem with the Harvard study is that it covers only the tiny fraction of small businesses that raise venture capital. According to the Kauffman Foundation, fewer than 1 percent of new businesses receive venture capital funding. Other businesses that are unable to receive venture capital investments must rely on personal savings or business loans for funding.
VC-backed companies are different from non-VC backed businesses in several ways:
- Rapid growth – Venture backed businesses must grow exponentially in their first few years of life to give investors a sufficient return on their investment. The result is boom or bust — most venture backed businesses either experience rapid growth or rapid death. Ordinary businesses can grow more slowly, which may affect their long-term survival.
- Business control – Owners of venture capital-backed businesses also cede a significant amount of control over their business to investors. Owners of non-VC businesses have complete control over day-to-day business decisions, which can result in different failure rates.
- Business type – According to a Bloomberg study, the top three types of VC-backed companies were in the Internet, software, and biotech industries. These businesses may have higher (or lower) failure rates compared to other types small businesses.
A study of business failure rates among VC-backed firms alone cannot be used to describe failure rates of all small businesses.
Study #3: SBA Study Of Business Failure & Success
In 2003, Brian Headd, an economist at the US Small Business Administration (SBA), analyzed 12,185 businesses. He asked the owners of these businesses whether they considered their ventures a success or a failure.
He found that while half of the businesses exited the market after four years, the owners of one-third of those businesses still considered their firm to be successful.
Let’s do the math to calculate the business failure rate:
- Businesses surveyed = 12,185
- Businesses that exited market after four years = 6,092
- Businesses which were successful according to owners = 2,030
- Business success rate = 66.6. % (6,092 businesses that remained in market + 2,030 businesses that considered themselves successful ÷ 12,185)
- Business failure rate = 33.3 % (100% minus 66.6%)
This study found that about one third of small businesses fail after 4 years. This lies in between the Harvard study findings and the BED data.
This study was based on business owners’ subjective perception of business success or failure. The study found that owners evaluated success differently based on their age, education, and past experiences. In addition, the type of business had an impact. Owners that wanted a stable, life-long business were more liberal in saying their businesses were successful than owners of a high-growth startup who wanted to sell off the business after a few years.
Why The SBA Study Is Wrong
Unlike the BED report, the SBA study does include sole proprietorships. Unlike the Harvard study, it also includes businesses in various industries and financed by various methods. So what’s the problem with this study?
Any study of business failure rates based on owner perception isn’t very helpful to people who are considering starting their own businesses. One owner may think her business was successful if she exits with $10K in profit. Another owner may only consider an exiting profit of $1 million as a success. Without a clear benchmark, you can’t compare the failure rate to your own business prospects.
In addition, we don’t know how the owners fared after they exited the business. Did they restart the business later? Did they pass the business down to family members? At the end of the day, not having an objective definition of business success and failure serves as a barrier in determining actual failure rates.
Bottom Line: Small Business Failure Rates
Next time you read a scary business failure statistic online, dig into the methodology and see what the study is actually measuring. Most likely, it doesn’t provide an accurate depiction of small business failure rates as we’ve discovered putting together this article. There are so many variables to consider, including how failure and success are defined, as well as sample size and representation.
What do you think about our findings on small business failure rates? Feel free to share your thoughts in the comments section below.