Business Failure and Dissolution

Related Terms: Bankruptcy; Liquidation

CLOSURES AND FAILURES: THE NUMBERS

In 2002, 22.98 million businesses operated in the United States, but the overwhelming majority of these were enterprises without employees. The U.S. Census Bureau maintains data on the closure of businesses with employees (a universe of 5.66 million firms) but without specifying the cause of the closure. Dun & Bradstreet Corporation tracks business failures, but its database clearly includes some one-person corporations.

The Census Bureau data, available from the U.S. Small Business Administration on its Web page titled "Firm Size Data," shows that in 2002, 586,890 firms with employees closed their doors; 569,750 businesses were launched. The Census refers to these as "deaths" and "birth." In most years births outnumber deaths by a small margin; 2002 was an unusual year. In 2001, a much more typical year, 553,291 firms closed their doors and 585,140 were started, a net gain of 31,849.

The terminology employed by statistical agencies does not make it easy to distinguish between business closures or dissolutions for whatever cause and business failures more narrowly defined as involuntary closures due to financial or legal failure. Some indication is provided by bankruptcy data. In 2002 38,540 business bankruptcies were equivalent to 6.6 percent of closures; in 2001, 40,099 bankruptcies were equivalent to 7.2 percent of "deaths." Brian Headd, a researcher for the Census Bureau's Center for Economic Studies looked closely at closure rates of small businesses. He found that 66 percent of small businesses that close are "unsuccessful"; the rest close for other reasons. Bankruptcy, of course, is an extreme form of being unsuccessful.

Another source of statistical data, maintained by Dun & Bradstreet Corporation and reported by the U.S. Census Bureau (see "Business Enterprise" under references), identifies business failures explicitly. "Failures" are due to insolvency, bankruptcy, or legal action. But these data, while explicit, are difficult to compare with federal data: the number of business concerns D&B uses as its base is much larger, almost certainly because the company includes some firms without employees; such firms are excluded from Census Bureau data. In D&B's report for 1994, for instance, 707,000 new incorporations are shown against 71,529 failures, a ratio of nearly 10 startups to 1 failure. The Census ratio for the same year was 570,587 startups for 503,563 "deaths," a ratio of 1.1 to 1.

The logical conclusion from these data, insufficient though they are, is that business failures are a subset of total business closures—and closures are much more common. Most businesses are dissolved voluntarily while still successful because owners close shop for whatever reason or sell their businesses to others who merge them into existing entities.

REASONS FOR BUSINESS FAILURE

Businesses almost always fail for reasons that are complex and intertwined. The Small Business Administration, citing two well-known authors (Michael Ames and Gustav Berle) provides a ten point list for consideration. SBA's list includes 1) lack of experience, 2) insufficient capital, 3) poor location, 4) poor inventory management, 5) over-investment in fixed assets, 6) poor credit arrangements, 7) personal use of business funds, 8) unexpected growth, 9) competition, and 10) low sales.

The first item in SBA's list is not only the most important cause of failure. In a way it includes all of the others. Robert Fairlie and Alicia Robb found, for instance, in a study published by the Census Bureau, that individuals who had acquired experience in working in a family business were much more likely to succeed in another enterprise—but their own. They had acquired what the authors called "human capital," i.e., experience.

The literature provides many lists like SBA's, and longer ones at that. They all touch on the same matters but in more detail. In a more systemic way, one might assign the causes of failure to poor planning, poor controls, incompetent execution, and slow adaptability. Planning, which relies on experience, of course, will correctly assess the market environment, including demand, competition, location, and availability of capital and credit. Operational planning will determine the efficiency of the enterprise and will ensure that financial controls are in place and are used to provide early warnings of trouble. Controls are vital to match purchasing to inventory and to trigger timely discounts when inventories become too old or too large. The business must not be started if capital is unavailable or credit arrangements are still too loose. Prospective entrepreneurs must cultivate a certain humility and realism about the competition. No matter how promising one's own product or service, the competition is not likely just to melt away. It may respond.

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