Why Businesses Fail and How to Prevent It

Updated on February 7, 2018
George Mikituk profile image

George is an independent small business consultant and business owner with a mission to help entrepreneurs improve their management skills.

The business labyrinth
The business labyrinth | Source

Causes And Remedies

Only 30% of new small businesses survive after two years and even those that do survive may not have put up the necessary firewalls to avoid failure in the future. There is a consensus on the reasons for failure that are well-planted in the minds of business support agents such as bankers and venture capitalists. Defining the principal factors that contribute to businesses failure provides an analysis tool for preventative measurements that every company must undertake. With the dominance of information technology, the creative destruction that has roiled the markets in the last two decades has made the task of recognition of the harbingers of failure much more critical than in the past. The time frame for reaction has been drastically shortened. But high technology is not the sole culprit. Many of the causes of business failure remain historically consistent because they deal with business fundamentals that are often overlooked or neglected.

Insufficient Funding

This is not strictly limited to start-ups. Many older, small, and even larger businesses become vulnerable due to poor financial planning, and inability to access timely funding for working capital. In too many cases the planning is almost exclusively focused on products and services. An entrepreneur may have developed an exciting new product, which in their mind is unique or offers novel features compared to existing products. They roughly break down the direct costs of material and labor, add some operating expenses and come up with a price that reflects what the market is willing to pay for a similar product, without fully understanding the cost implications on profitability. In many cases, the products or services are sold at a loss. This quickly exhausts their cash reserves, which usually comes from their own initial investment or/and from supportive family and friends. Funding plans for young companies are often greatly understated because the sales estimates are too optimistic and cost projections are too low.

Remedial Action

In the financial projections, create low-high-medium revenue numbers and operate with the low estimate.

  • When investing your own money and that of family and friends, add a multiple of 1.5-2 to your preliminary needs and wait until you realize this funding goal before starting your business activity.

  • Anticipate cash flow shortages in the beginning, and organize other sources of funding such as grants and government subsidies.

  • Develop a good relationship with your bank manager and provide a business plan. Set up an accounts receivable supported line of credit after six months of operation.

  • Set up a cash flow spreadsheet that offers strict control of cash on a weekly basis.

Failure to Plan

The excitement of starting a new company quickly wears out when faced with the grueling task of fighting for market share in your chosen industry. Having a clear understanding of your market involves research into your product and service differentiation and that of the competition. Also very important, are price modeling, promotional mix selection and distribution channels that reflect the reality of the industry in which you are competing. Market size, segments, digital marketing options are other planning prerequisites. Stating the strengths, weaknesses, opportunities, and risks that the business will face is part of the knowledge base that is needed to at least provide a reasonable chance for success. The plan must then be put into a context of financial goals such as revenues, direct costs, fixed costs, gross and net profits. Unfortunately, most small businesses do a poor job in this type of planning, or even worse, operate blindly without plans for goals and objectives and without formal budgets.

Remedial Action

With so much information available on the Internet and competitor websites, there is every opportunity to formulate a reasonable business plan. Use templates if necessary, which you can often find for free on the internet

  • The business plan must have a carefully crafted budget and forecast for the next three years, with conservative numbers that are realizable under normal market conditions. The budget must be tracked with a monthly variance report that underscores deviations from the plan.

  • Bond with your bank manager early on in your business career. Let them see your plan, and become part of your vision and direction.

  • Get other members of your team involved in the planning, so that they know where the company is going, and what their role is in supporting the goals and objectives in the plan.

  • Analyze and revise the plan on a quarterly basis to meet any new developments in the marketplace.

Destructive New Technology

All industries are subject to new technology. It is just that in the high- tech industry the changes happen much quicker. One such example is the tremendous improvement in micro processors that has spawned ever faster, smaller, and more complex consumer devices such as smart phones. There are other industries that seem to change at a relative snail's pace in comparison. But robotics, artificial intelligence, and improved computers affect all businesses to a greater or smaller degree. Some manufacturing is now almost wholly done by programmable robots. 3D printing has revolutionized the parts supply chain. Homes have been connected to the Internet-of-Things and turned into smart systems. Creative destruction has taken down many companies that thrived just a few years ago. Product and service obsolescence is a recurring problem in this environment. As a small business owner or manager, you must become aware of what is lurking on the horizon and take action to protect yourself.

Possible remedies

  • Stay on top of your industry's technological breakthroughs by subscribing to an online or printed version of a relevant trade magazine.

  • Join an association that represents the type of business that you are in, and conducts regular forums or meetings where new technology is discussed.

  • Promote innovative ideas within your own company through an incentive plan. Remember that some of the great ideas came from garage operations. Hold regular brain storming sessions with your employees and external experts, where new ideas can be discussed.

  • If you have the financial resources, seek investment opportunities in new companies with technological breakthroughs.

  • Upgrade your products and services to stay in tune with the times and avoid obsolescence. Perform an audit of features and benefits in competitive products and services and determine what you need to do to match or exceed them.

Failure to Seek Outside Assistance

The managers of a young company must realize very early on that they may have a weak understanding of some key pieces of the management puzzle. The start-up entrepreneur may be a whiz at the technical side of the business, but be weak in sales, marketing, finance, and organizational controls. With limited resources, it is sometimes difficult to allocate scarce financial capital in hiring expertise, either on a permanent or consultative basis. There is also the misdirected pride of trying to do it all yourself and learn by trial and error. This is a misguided attitude that often leads to solvable problems becoming permanent barriers to survival and success. Managing a business is a complex process that requires a number of specialists

Look for External Help

  • Networking with a friend or acquaintance, who has a deeper experience in business is an economical way to get help - sometimes at no cost. These senior people are often willing to act as mentors and can become investors at some stage. Set up regular informal meetings with them over lunch or breakfast and pick their brains for useful information.

  • Hiring the required expertise from the pool of consultants available in your area can be cost-effective in the long run. Be careful that you evaluate the real cost of such consultants, particularly those who charge high hourly rates. There are some helpful business related websites that provide the business tools that you need at very reasonable cost. Use the Google search engine for keywords such as small business restructuring.

  • Join a local Chamber of Commerce, and develop a network of business people who face the same issues and problems as you and share their experiences at meetings.

Talent Pool Deficits

Realize that no matter what you may know, and how much you apply yourself to the business you cannot succeed alone. However, surrounding yourself with people who have the knowledge, experience, leadership, and passion to help you make a business succeed is a difficult quest for a small business entrepreneur. Top talent in any domain is expensive. On the other hand, setting up a company by choosing those who are just looking for an occupation, or friends and relatives who need the job leads to early problems, and possibly creates nepotistic tendencies that are very difficult to overcome. It is essential, particularly in the early going, to develop creative incentives that will attract the necessary talent.

Be Creative With Benefits

  • If you cannot match the salaries needed to attract the top guns in the industry, or at least find experienced people, then be creative in offering early equity participation through a shares incentive plan.

  • Sell management candidates on the growth potential of the company. Demonstrate this clearly with a strategic plan and financial data that shows a bright future. which they can share with you.

  • Don't be afraid to offer a salary that exceeds your own. Look at your remuneration potential over the long term, and realize that you need a solid team to get you there. As the owner, you can take dividends in the future, and other perks available to proprietors once the business grows. Don't be the first in line for rewards until the sustainability of your company can be reasonably predicted.

  • Talented people look beyond salaries. If you have exciting new products or services that offer creative challenges, it becomes an attractive enticement. Make that evident to potential partners and employees.

Pricing for Loss

In order to generate profits, it is obvious that your revenues have to exceed total costs. However, many small companies base their pricing strictly on competitive pricing. This is a recipe for early disaster, because larger companies may be employing loss leader and other pricing strategies that discourage new entries. The other trap in pricing strategies is to gain market share and sales volume at the expense of profits. This strategy has worked for some mega Silicon Valley entrepreneurs, who have developed high tech or social media products and services with immense market growth potential. This is definitely not the path that the great majority of businesses can afford to take. Pricing must absorb the direct and fixed costs, and generate profits that are commensurate with the industry average.

The often repeated pitfalls for small businesses is omitting or understating their overhead contribution. Such direct costs as labor, labor benefits, materials, shipping costs are fairly well known, but when it comes to overhead contribution and labor burden it is often inaccurately calculated or misunderstood.

Pricing for Profitability

  • The hourly rate of labor does not cover the entire cost of labor. You must add the labor burden, which is the none productive benefits paid to production employees. This includes: vacation, statuary holidays, paid sick day, and government contributions such as health care and social security. Use the payroll data to define the labor burden as a percentage of direct labor on an individual or average employee basis.

  • The overhead contribution factor is derived from the historical income statement and represents the total operating costs, such as management salaries, rent, interest on loans, employee benefits, etc. They should be expressed as a percentage of direct labor and material cost and added to the cost side of the price estimate.

  • In many cases, pricing is software driven, but you should always verify that all the costs are accurately assumed in the program. Understanding the components of pricing avoids serious pricing errors.

  • While it is essential to compare your pricing to the competition, you must always refer back to your cost-based pricing model to see how far you can go to match their pricing. Use other marketing strategies to overcome pricing issues such as product improvement and diversification, creative promotions, and improved customer service programs.

  • Recognize when large competitors are simply using loss-leader strategy to squeeze the competition. This is usually a short-range plan and often related to a small list of selected products.

  • Be aware of the flexibility that a small player has in any segment, and use it to your advantage. You may be able to offer more personalized service that overcomes the disadvantages of offshore customer services offered by big firms. In many cases, the relatively smaller overhead expenses in a small business can provide more room for price discounts.

Avoid the bumps in the road to success
Avoid the bumps in the road to success | Source

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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