How risky is starting your own business?

The conventional wisdom on starting your own business is that the odds are against you. The frequently cited statistic is that 75% of all businesses fail within the first 5 years. However, the devil is in the details. The typical methodology of measuring business failure is to tabulate the number of employer accounts opened with the U.S. Department of Labor and the number of employer accounts closed in any particular year and using employer account openings and closing determine how long a typical employer account will remain open. A closing of an employer account is generally marked as a business failure.

However, employer accounts close for a wide variety of reasons other a termination characterized by bankruptcy. Businesses merge. Businesses close down voluntarily. Owners retire. Businesses move. In a 1996 study, researchers found that if business failure was solely defined as bankruptcy, the business failure rate drops to under 1%. The same study found that small businesses cumulatively failed 64.2% in a 10 year period but less than 6% due to bankruptcy. This is a far cry from 75% failure rate within 5 years.

(admittedly, given the difficulty in tracking a sector as large and diverse as small business, the statistics tend to be everywhere. Entrepreneur Magazine found an average life of a small business to be 11.2 years and 40% of small businesses survive after 6 years).

What the statistics tend to bear out is something I saw quite often as a lawyer. Businesses fail because the opportunity costs of doing something else outweighed continuing to run the  current business rather than the common perspection of some cataclysmic event ending the business. Owners found jobs. People retire. People sold out.  Entrepreneurs start other businesses (serial entrepreneurship is a common “ailment” among entrepreneurs. As Milton wrote: “better to rule in hell than serve in heaven.” There is a certain addictive quality of being the fool in charge as opposed to listening to another fool).

Beyond the statistics though, my professional opinion is that many business owners bail out too quickly; a non-tech business generally does not gain traction until year 2. Alternatively, owners shut down businesses quickly for two major reasons- poor cash flow planning and a failure to appreciate sales cycles properly (the quick and dirty is if you are in a high volume, low margin business you have to measure turnover carefully.  If you are in a low volume, high margin business your expense control and cash velocity are key).

This impatience draws a certain parallel to the average investor. The Dalbar Qualitative Analysis of Investor Behavior found the average holding period of a stock fund ranges from 2.46 years on the low end to 4.31 years on the high end. In most cases, this is far too short of a period of time for most retail investors to benefit from an investment.

Regardless of whether an entrepreneur stays a short or long time, how do they end up doing? The National Federation of Independent Business estimates that 39% of businesses are profitable, 30% break even, 30% lose money and 1% cannot be determined. This statistic, like all statistics, is subject to some debate.

However, what is striking about this number is it parallels surveys of real estate profitability. The U.S. Census of property owners and managers found 41.4% of those surveyed reported they made a profit, 16.2% broke even, 26.7% lost money and 15.7% did not know how they did (not knowing whether you made a profit, broke even or lost money is probably a good indication its time to think about not being in real estate anymore).

There is clear overlap between small business owners and property owners since the latter is a subset of the former. However, the larger point being that the degree of risk of starting a business is not materially different than investing if you believe the statistics to be true.

As a society, we tend not to embrace entrepreneurship given a minority of the population are entrepreneurs (in North America, self-employed taxpayers compromise less than 20% of all taxpayers) and our ignorance tends to impart a greater degree of perceived risk. Yet, in the same breath, those who dismiss entrepreneurship as too risky turn around and flip their stocks too quickly or become real estate investors with relatively the same success rates.

Entrepreneurship is not a lifestyle choice for everyone. Certain people are destined for business failure.  However, it is unfair to gloss entrepreneurship as a riskier investment choice. It is risky if you don’t know what you are doing but the same concept applies to investing as well.

To state this another way, what determines the risk of starting a business are the same factors that would make investing risky: lack of knowledge and education, lack of emotional control, lack of understanding of the market. Just because investing in stocks and bonds is more popular than investing in starting a business does not make the venture any more or less risky.

As an editorial note, it is important to continue to nurture small businesses even if you are not an owner manager. After all, small businesses are job creation machines and the economic recovery will not coming from big business but from small business and a better indicator of a main street recovery will not be stock prices but small business hiring numbers. As I stated before, my true metric of an economic recovery will be small business hiring numbers.