Top Ten Reasons why Small Businesses Fail
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UPDATED: Dec 13, 2012
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Each year, entrepreneurs set out with noble ideas and high goals for business success.
Some succeed while others fail.
Although there are always unforeseen issues that can trouble a business, most small businesses fail because of similar reasons.
The Small Business Administration (SBA) cites 10 reasons for small business failure. The reasons are provided by Michael Ames, author of textbook “Small Business Management” and Gustav Berle, author of “The Do-It-Yourself Business Book.”
- Lack of experience
- Insufficient capital (money)
- Poor location
- Poor inventory management
- Over-investment in fixed assets
- Poor credit arrangement management
- Personal use of business funds
- Unexpected growth
- Low sales
Dr. Michael D. Ames, Professor of Management at California State University Fullerton, said that although his book is almost two decades old, it still offers valuable ideas for business owners. But he told loans.org that he “would overlay it with another list of 20 years or more of experience.”
Lack of experience
Entrepreneurs can be inspired by a sudden business idea or a lifetime drive to fulfill a dream, but sometimes a drive is not enough. Sometimes experience is more important than the initial idea. If a new business owner does not have the expertise to start a certain business they should hire on educated staff that can assist in technical areas.
One area for failure, due to inexperience, is a lack of purpose.
“You have to have a clear worthwhile purpose if you are going to get a hold of the resources to be successful,” Ames said.
He said a clear purpose generates positive energy “like a lightning bolt from the sky.” Without proper experience, a business owner would fail at utilizing the energy.
Another area of experience is leadership.
Through his extensive research, Ames said a lack of leadership was a major root cause of failure and that he kept asking himself, “What about leadership is teachable?”
Ames has made it his lifetime goal to tackle this question and inspire local entrepreneurs to lead their employees towards success. He founded the award-winning Small Business Institute under the University’s Center for Entrepreneurship and has provided in-depth counseling to over 1,500 business owners during his career.
Understanding a new business’ potential customers is extremely important. Ames said that a lot of businesses spend large amounts of money, often falling into debt through use of large or small business loans to do so, before they truly understand their customer’s needs. They end up “building what they want versus what their customer needs,” Ames said.
Sometimes products are simple, but if the customer needs the product, they are more likely to accept it as simple, instead of labeling it as inadequate. A new owner should always take the customer into consideration.
“Understand what they want versus what you think they want,” Ames said.
Once a purpose is realized, funding becomes very important. Ames believes in the system of the SBA’s small business loans.
“It is a really brilliant way to leverage resources,” he said.
But a clear focus should remain. Ames said the purpose of a small business loan “is not to go out and party, but to have an effective business. Having an effective business does not necessarily require schooling but it does require a clear plan and position.”
And Ames warned, no small business loans should be requested before a customer market is understood. Networking for community members and future customers is vital. Networking allows new business owners to seek out strategic alliances. At the very least, the people you meet could turn into potential customers.
Location is real estate 101, but this bit of common knowledge does not always transfer to new business owners.
Picking out a bad location is likely an outcome of inexperience. If a luxury car dealership wants to open up, they should not open up in a poor neighborhood. Business owners need to understand their target audience. If they stray from this goal, whether it is to pursue lower rent or a shorter commute, the owners risk losing the audience that keeps their business alive.
Poor inventory management
Without a sensible plan for controlling inventory, a business is likely to struggle.
Whether the company records inventory electronically or manually, the practice is all the same. A business needs to know how much product it has, in order to estimate costs for the future.
Additionally, if inventory is lost, unless the business wants to fold immediately, they will need to find extra capital to purchase replacement inventory. This could force a new startup to taking out additional small business loans, and further launch the startup into debt. If the company has any prior outstanding small business loans that become difficult to manage as a result, this situation can lead to credit issues for the company, including higher interest rates and larger payments on future small business loans.
Over-investment in fixed assets
Fixed assets are items such as property and equipment that cannot be easily converted into cash.
Just as the housing market over-invested in home equity, so do businesses. A business should not overly invest in their fixed assets such as their office building, property, or equipment. Although the assets can technically be sold for money if needed, the business will not be able to run without the necessary items.
Both fixed and current assets are usually labeled during the creation of a business plan. One of the reasons why a business plan is necessary for new small business loans is because of its overarching importance for the financial stability of the company, which is a measurement of a lender’s risk. Without a business plan, new and existing companies lose track of their goals, financial security, and plans for the future.
Pepperdine University has an excellent guide on how to write the perfect business plan for those interested in learning more.
Poor credit arrangement management
Businesses credit scores are just as important as personal credit scores. When businesses pay bills on time and accept positive forms of debt, they are able to access better deals in the future, such as lower interest on small business loans. The owner and employees of a business should treat the business’s credit report as their own. Small business loans, credit cards, and vendor bills should be paid off as soon possible in order to keep that score at high levels.
In this era, many consumers use online resources to research companies. Low credit scores and bad vendor reports can hurt the businesses reputation and well as its bottom line.
Personal use of business funds
Owners are sometimes their worst enemies. Whether they push through with a bad idea regardless of their customer input or they pick a poor location, errors on the owner’s side can destroy a business.
One of the worst offenses is personal use of business funds. Strict accounting should be utilized, if only to pay down small business loans as soon as possible. If funds are used for personal items such as buying gas or purchasing flights for a summer vacation, the business can suffer.
Owners should use business tools, property, and company finances only when it will help the business. Beyond legal repercussions, if owners fail to identify funds properly on tax returns, it creates a difficult situation for owners and staff members. The business accounts and tools should be used to benefit the company and not the employees during their regular lives. If an owner is running short on money, they should not dip into the business account, but rather figure out why they are unable to pay their own bills. Are they not being paid enough each month? Are they spending too much in relation to the success of their business?
These important questions should be asked instead of dipping into company resources when times are hard.
Although success is a top outcome for most businesses, owners are not always ready for the outcome if it occurs. Some small businesses only prepare for local and small profits, and when the opportunity to expand comes, they fail.
For example, being in charge of one restaurant is very different than managing five restaurants spread out across the state. It involves hiring more staff including managers to oversee each location. Although the potential to earn increases, so does the potential to lose profit.
Ames said that a reason for failure is a lack of testing.
“People don’t test enough. They don’t test out their ideas enough before they get bigger,” he said.
This could lead an owner to take out larger business loans to fuel an expansion that never occurs. All that is left is a pile of debt, without a means to pay it off. Owners should expand cautiously and with purpose.
Competition is a given in most businesses.
Successful businesses should use competition to their advantage. Review what other similar companies are doing, or deals they are offering. No business is ever finalized and changes can (and usually should) be made frequently. If a competing local shoe store is offering a great deal on certain running shoes, instead of being empty during the competition’s sale, an opportunistic owner could advertise a sale of his or her own.
Competition does not have to be a bad thing. Having a strong network of similar businesses in a market can help all of the businesses succeed. A new owner should network with their competition as soon as possible.
“The resources you have under your [network’s] command are more important than the resources you [alone] have,” Ames said.
Low sales can be attributed to many different things, but one thing is for sure, if it doesn’t sell, a business is not making money. But this happens to almost every business, even large corporations. The company’s success, even through poor sales, is figuring out what does not work, and fixing the problems.
Ideas are important, but as Ames said, “You have to execute or you are not going to make a profit.”
Each year, new businesses open across the country. At year’s end, some have closed while others continue on. What keeps them alive is not only that first business idea, but a commitment to their customers to fixing their errors and to following good business guides, such as this one.