Avoiding the Traps that Cause New Businesses to Fail

by J. Tol Broome, Jr.

Published in the January 2001 Issue of Anvil Magazine

You've undoubtedly heard the horror stories about small businesses failing during their first few years out of the gate. The Small Business Administration estimates that about 60% of businesses fail during their first five years of operation. There are many reasons that new businesses fail. Here are ten of the most common causes of failure, along with some advice on measures you can take to avoid these problems in your business.

1. Under-capitalization

This is the number one small-business killer. Most small businesses are started as micro-businesses with very little capital. The business can survive for awhile with little capital, particularly if it is being operated in a small rented space. However, an under- capitalized business eventually runs out of money, which causes delays in getting orders filled. This leads to dissatisfied customers who stop buying. And no sales leads to no more business.

There are a couple of critical business stages at which capital is key. First, as you are starting the business, make sure you have a cushion available to get you through the peaks and valleys that inevitably will occur. This can be accomplished out of your own personal funds or through a bank line of credit. And if you don't have much money saved and your bank won't approve you for a line of credit, the next best thing is equity funds from a friend or family member. You may be reluctant to give up some of the ownership of your small business, but having funds available to help you through cash flow shortfalls might be the difference in whether or not your venture makes it.

The second point at which a capital crisis is likely to occur is two or three years after the business has been started. The key here is to anticipate this crunch before it occurs. If your business has been profitable, you might have more success than you did at first in obtaining bank financing. An equity investment might get you through this period, as well. The key with either bank financing or an equity investment is to plan ahead. Don't wait until you start getting behind or until you have a huge order to fill before going to the bank or the investor.

2. Inappropriate Financing

While we are on the subject of capital, we would be remiss without addressing the inappropriate use of financing as a major cause of early small business failure. There is a tendency for the new business owner to use any source of money available to finance the entity, regardless of the interest rate and repayment schedule. This can be disastrous.

No matter how tempting it may be, avoid the use of high-interest rate credit cards to finance a new business venture. With the regular onslaught of direct mail applications we all receive on a weekly basis, revolving credit is easily accessible. The problem is that credit card companies charge 18% or more for the use of the money. As the use of credit cards mounts up, so does the monthly interest expense and the minimum monthly payments. Soon, the small business owner is sinking all of his/her profits into the credit card payments, but the balances aren't going down. If this cycle isn't halted, the business finally fails.

The other pitfall related to financing is inappropriate repayment terms. Some banks will readily make available 90-day notes to new small businesses. However, many small business continually run short on working capital and need to roll profits from one project into the next one. As a result, the short-term bank loans don't get paid off. One day the banker gets nervous and calls the loan(s). The next day the business goes belly up!

3. Not Enough Sales

It is rare that a small business is started in which the owner doesn't think that his/her idea ranks right up there with sliced bread. Unfortunately, if you don't find some customers who agree, the business is doomed to fail. If you are in the beginning stages of starting a business, test the waters before diving in.

Here are three suggestions: First, talk with prospective customers about your ideas to see if there will be viable buyers. Second, talk with others in your industry. Many competitors are quite willing to share information with each other. If you can't find someone locally who is selling a similar product, you should have no problem finding someone from another part of the country who is.

Third, attend a trade show or two before you get serious about your business. This will assist you greatly in learning more about what sells and what doesn't. A trade show also is a great place to find prospective customers and other business owners in your industry to carry out suggestions #1 and #2.

4. Too Much Sales

In my 16 years in banking, I have seen nearly as many new businesses fail because of too much sales as I have due to not enough business. As mentioned previously, many small businesses are under-capitalized. When an under-capitalized business experiences rapid sales growth, a tremendous cash crunch can result.

The typical scenario goes something like this: A business enjoys some early success. Gaining confidence, the entrepreneur begins advertising more heavily. Interest is very strong. In fact, it is overwhelming. Business doubles overnight. This creates two problems: 1) money to buy the inventory; and 2) staffing to handle the increased traffic. Customer service problems abound, and the business's reputation is seriously or even fatally damaged.

The best suggestion I can offer to avoid this trap is to manage your growth. This may actually mean turning down business at times. But you will be much better off with a bunch of people on a waiting list than you will with a bunch of people complaining about your deteriorating quality and/or turnaround time.

5. Lack of Financial Understanding

Many small business owners go into business solely on the strength of their respective creative talents or technical expertise. This works fine at first, because the numbers are pretty simple. As the business grows, however, the numbers get much more complicated.

Regardless of the scope of your business, you need to invest a significant amount of time in understanding the financial side. You can accomplish this over time by asking questions of your banker, your accountant and other financially astute small business owners. You might take some accounting and finance classes at your local community college. Increased financial competence will translate to a more profitable and efficient business, which certainly will make your life easier.

6. Economic Problems

This is a tough one because there is little you can do to control the national or local economy. Still, economic problems often are the cause of business failures. The national economy was strong in the 1990s, but there were pockets around the country that suffered. If you were located in an area of the United states with a strong reliance on manufacturing, your perspective of the economy was - and still is - probably quite different than that held by someone running a small business in California's high-tech Silicon Valley. Even on a national basis, a recession is inevitable and likely to occur sooner rather than later. Of course, a new business can survive in an economic slowdown. If you see one coming, avoid any heavy capital expenditures and extensive new hirings. And if your business primarily relies on one or two key customers for orders, try to diversify so you won't be devastated by a big drop-off in business if a major customer ceases ordering.

7. Disaster with No Plan

As with economic downturns, the occurrence of disasters are out of your control. However, how you plan to deal with a disaster can be the difference between survival and failure. The first suggestion is to ensure that you are adequately insured. Don't try to cut costs by under-insuring. If your inventory and equipment and other assets aren't adequately covered and you have a fire, you might not recover. Also, make sure you have the proper level of insurance for flooding, workman's compensation and liability.

If your business is heavily reliant on a personal computer for its operation, back up your files regularly and store them off site or in a fireproof safe. Many a new small business has been doomed by a computer crash or fire in which critical computer files were destroyed with no backup.

8. Death or Disability of the Owner

This is a major cause of small business failure that often is not considered as a risk. Let's first deal with disability. If your family is dependent on the income generated by your business for day-to-day expenses, you should carry long-term disability insurance. Unless you are 60 or older, you are far more likely to file a claim on a disability insurance policy than you are on a life insurance policy. As for the death of a small business owner, many simply can't survive the loss since the owner and the business often are one and the same. However, adequate life insurance is still critical, as it protects your family from financial hardship in the event of your death.

9. Expanding the Business/Owner Burnout

Many businesses fail as a result of a major expansion. Increased expenses (rent, insurance, utilities, taxes) that result from a larger location can mount up and sap the profits that were being made when the business was operated in a hole in the wall. Owner burnout is a common result. Running a one- or two-person operation was fun. Managing ten or more people becomes a drudgery.

There are two suggestions here. First, count the cost of commitment before you expand. A larger business may require a major commitment of time and resources on the part of the owner. Second, run the numbers. Share these financial projections with your CPA, banker and other business owners to make sure you haven't forgotten anything. Your business simply may not support the increased expenses that will result from the expansion. And it is certainly better to find this out ahead of time! 10. Lack of Long-Term Financial Planning

Whether you run a multi-million dollar company or a small two-person shop, long- term planning is essential. If you focus all of your efforts as the owner on putting out the day-to-day fires and none on looking out toward next month, next year or the next decade, you just might wake up one morning to find that one of those fires has engulfed your business entirely.

From the time a business is started, a long-term financial plan should be maintained and updated regularly. Long-term planning will help you with such important decisions as choosing which trade shows to attend, what materials to buy and when to buy them, when to go see your banker and when to consider expanding. As the saying goes, if you fail to plan, you might just be planning to fail.

Most new small businesses will face challenges along the way that will prove critical to ultimate success or failure. It is hoped that these points, detailing some of the key pitfalls, will assist you in identifying and dealing with them, in order to make sure that your business stays in business.

Return to the January 2001 Table of Contents

Return to the Commentary Articles page