Blog

Why Small Businesses Fail

Finance

|

3.2.21 |

Joseph Darby

Most small businesses fail

Running a successful small business is incredibly difficult. Few people have the skill, stamina, and grit to survive over the long-term, which is why it’s well-known that most New Zealand businesses fail within their first five years. This is consistent with similar jurisdictions overseas.

If it wasn’t hard enough already, over recent years small businesses have dealt with a seemingly unending series of natural disasters, lockdowns, border closures, and recessions. Much of this is yet to play out in publicly available data – so the business failure rates are soon likely to be even higher.

Figures from the Restructuring, Insolvency and Turnaround Association show all types of formal insolvency appointments; liquidations, receiverships and voluntary administrations are climbing.

Several other factors are at play here too.

Inner City Decline and Small Business Failures

Some inner city locations in New Zealand have been left a lot barer than you might expect as many former office-workers now work remotely. This has hurt many cafes, bars, retail outlets and others as there are less people frequenting the areas to shop, eat, drink, get their haircut, or run errands in their lunchbreaks.

To double-down on this, some (though not all!) inner city New Zealand areas are struggling with spiking crime, homelessness, partially completed infrastructure projects, and commercial vacancies. This can become a spiral where:

The inner city becomes less appealing and more dangerous to visit, then
Less people go, more businesses close and more people work from home, so it’s even less appealing to visit the inner city, and
The cycle restarts.

Recession and Rising Costs Hits Small Businesses Harder

Small businesses generally struggle more when the going gets tough. Small businesses often have higher costs relative to large competitors (lesser economy of scale), might have less diverse products, services, or customer bases, and typically have more debt. This could be debt in the name of the owner, sometimes lent against the owner's own family home as that obtains much better interest rates and terms than business lending.

While some businesses have no choice but to close, others might consolidate their brands by being brought by a competitor or by merging to form a larger entity.

Background: Why Start a Business and How to Succeed?

Regardless of what’s going on with the economy or otherwise, what does it take to become the exception to the rule? Why do so many entrepreneurs and small businesses fail, and how can you avoid their ranks?

As you contemplate going into business for yourself or explore the risks in your existing business, beware of these common pitfalls and traps.

Wrong Reasons to Start a Business

Many people start businesses with a poor ‘foundation’. This is probably because of the publicly inaccurate impression of entrepreneurship. We see only the success stories like Elon Musk or Jeff Bezos — because they’re the ones that are featured in media headlines. No one wants to read case studies about failed businesses, so we don’t hear about them, even though they make up most business attempts.

Entrepreneurs tend to start businesses for one or more of three overarching reasons: freedom, money, and to do good. It might be they think they’ll earn a great deal of money quickly, and they love the idea of “firing their boss” and working for themselves. Alternatively, some people want to solve great problems, and in doing so are rewarded financially as a by-product.

If your motivations are financial, starting a business comes with high risk, no certainty of getting paid, and plenty of stress. If you want money, there are plenty of other ways:

These options don’t require the risk, stress, and long hours that entrepreneurship does.

Which raises the second point of chasing freedom. Eventually, if your business survives long enough, you can create a degree of freedom to work when and how you want. But starting a business requires longer hours than working a 9-to-5 job does. The buck stops with you. You must wear every hat at first, from marketing and sales to accounting and bookkeeping to actually creating whatever it is your business sells. You work harder than employees work, often with little to show for it at first.

And finally, some start businesses with a greater purpose in mind or to solve a pressing issue. An example of this is Savers. Savers is an op shop (“thrift store”) chain with locations in the US, Canada, and Australia. The organisation purchases its products from non-profit organisations that have received the items as donations then sells the items at affordable rates at its retails shops. Savers recycles any items that don't sell and also partners with a number of non-profits to create jobs, assist people with disabilities, and support at-risk children.

Why Most Small Businesses Fail

As you set off on your journey toward profitability and expansion, watch out for the following snares and missteps that trip up so many of your fellow small businesspeople.

1. Run Out of Money

Accountants call this being “under capitalised”.

In entrepreneurial circles, a common metaphor is a plane building up speed on the runway, trying to take off. Often entrepreneurs look for ways to “extend the runway,” to find ways to survive until they reach profitability and “can fly”.

2. Poor Market Research

Imagine going through all the work to create a product or service, launch a business, create comprehensive marketing campaigns, pay staff, pay suppliers, and spend a ton of money on advertising or software development — only to discover no one wants what you’re selling.

Or, to discover that someone else is already selling something even better, cheaper, or faster than you can offer. It’s a recurring theme for why so many businesses fail.

One issue in New Zealand is scale: piles of business funding can be invested into areas such as software specific to the New Zealand market – ensuring the software works with our unique regulations and tax rules, and so on – only to find it becomes uneconomical as the total addressable market within New Zealand is so small relative to the software investment required.

3. Not Enough of a Niche

Doing market research and competitive analysis isn’t fun, largely because it bursts your balloon. You realise just how apt your competitors are and how crowded the existing market is.

Too many entrepreneurs aim for the widest possible market — the largest pool of potential customers. They try to be everything to everyone to capture as broad a portion of the market as possible. And in doing so, they play to their competitors’ strengths.

Resist the urge and instead go in the opposite direction.

4. Personal Crisis or Circumstance

Not all businesses fail for business reasons. Many fail because of personal reasons, such as health crises, divorce, or a rift between business partners.

Take health crises, for example. It takes incredible stamina to run a business. If a health crisis hit you and you had to stop working or scale back your hours, could your business survive?

For that matter, yours isn’t the only health that could derail your business. What if your spouse or child got sick and needed more care? Or if your family needs better health insurance than you can pay for as a small-business owner? If you have a partner, what happens if they get too sick to work?

Divorce and business partners falling out can also derail small businesses.

This is often described as key person risk.

5. Skill Gap – Marketing and Sales

Just because you know how to manufacture widgets, programme software, or some other task doesn’t mean you know how to design and execute marketing campaigns for your product or service. Or how to pick up the phone and perform direct sales effectively.

Marketing and sales involve completely different skill sets than whatever you think your core business is. But when you go into business for yourself, marketing and sales become crucial to your success.

Which means you’d better get them right, and quickly.

6. Failure to Build the Right Team

Small businesses are a team sport, even if you don’t plan to hire any employees for a while.

Too many entrepreneurs try to go it alone. They don’t bother finding a mentor, consultant, or coach, don’t bring on supplemental help for tasks they should outsource, and don’t continuously learn and read within their niche. Let alone the likes of lawyers and accountants.

As the saying goes, smart people learn from their mistakes; wise people learn from others’ mistakes. Chances are that every mistake you’re likely to make has been made before.

Which means you can avoid making them if you get help.

7. Run Out of Grit or Purpose

Call it drive, motivation, will, purpose, or any number of other words. But there’s something inside you that enables you to get out of bed every morning and rise to the challenges that the day throws at you.

Most people don’t need much of this drive. They get a steady payday to compensate them for going through the motions of their daily grind. It’s enough for them.

Entrepreneurs don’t have a steady payday, and their grind is infinitely harder. They face countless challenges that employees don’t, with no guarantees that they will surmount them. Any one crisis could shatter their business — and entrepreneurs face a never-ending string of crises, week in and week out.

Sometimes entrepreneurs simply run out of drive. They know life is easier as an employee, and in the low moments, the simplicity of clocking-in to a regular job and having a steady payday calls out like a siren song.

8. Provisional Tax in Year Two

Provisional tax is income tax you pay in instalments during the year. Every individual pays income tax if they earn income, and companies do too.

Self-employed people, rental property owners earning passive income, and people who earn non-PAYE income all need to pay their own income tax.

You pay provisional tax if your tax bill for the last tax year is more than $5,000. When you first go into business in New Zealand, you don’t actually have to hand over any income tax to IRD for quite some time (unless you are going to be earning over $208K in profit for your first year – then different rules apply).

The usual financial year ends on 31 March – then your financial accounts and returns are prepared and any income tax payable for that year is due to Inland Revenue by the 7 April the following year – so in practice you get up to 24 months trading before you must pay your first years’ worth of tax to IRD. This tax is called Terminal Tax.

However, in your second year of trading as a business you probably will need to pay provisional tax. This means you must pay income tax for your second year of business in the second year – not a year later. It’s like paying as you go rather than paying in arrears. This means you probably need to pay two years’ worth of tax in your second year of business, which creates quite a cashflow problem for many small companies!

Tax can be a tricky area, so best to seek help from a suitable tax adviser or accountant.

The Bottom Line – Why Small Businesses Fail

We’re inundated with success stories about people who hit it big by becoming their own boss. But when you dig into these stories, you rarely get any type of useful tips on how to become a successful entrepreneur.

More often than not, new businesses fail. But if you avoid the common reasons above, your chances of success go up dramatically.

When in doubt, get expert help from people who have already succeeded. You don’t need to reinvent the wheel, and you don’t need to make every mistake in the book on your own. Avoid the most common mistakes because you’ll surely make plenty of unique ones in your own business as well!