Business Failure and Dissolution Law and Legal Definition

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.

"Unexpected growth" may appear to be an unusual cause of business failure. It is relatively common because the owners are dizzied and confused by sudden success and fail to maintain discipline in dealing with a rush of orders. The growth may be temporary—but they over-extend themselves in anticipation of its continuing. They may expand too soon. They cannot get the financing to meet the demand. The market, disappointed, may suddenly turn away and leave them with very high commitments to vendors.

BANKRUPTCY

Bankruptcy is a legal proceeding, guided by federal law, designed to address situations wherein a debtor—either an individual or a business—has accumulated debts so great that the individual or business is unable to pay them off. It is designed to distribute those assets held by the debtor as equitably as possible among creditors. Bankruptcy proceedings may be initiated either by the debtor—a voluntary process—or by creditors—an involuntary process.

Chapter 7 Bankruptcy Individuals are allowed to file for bankruptcy under either Chapter 7 or Chapter 13 law. Under Chapter 7 bankruptcy law, all of the debtor's assets—including any unincorporated businesses that he or she owns—are totally liquidated, and the assets are divided by a bankruptcy court among the individual's creditors.

Chapter 13 Bankruptcy This is a less severe bankruptcy option for individuals. Under the laws of Chapter 13 bankruptcy, debtors turn over their finances to the court, which distributes funds and payment plans at its discretion.

Chapter 11 Bankruptcy Chapter 11 bankruptcy law is designed to provide businesses with the opportunity to restructure their finances and debt obligations so that they can continue to operate. Companies usually turn to Chapter 11 protection after they are no longer able to pay their creditors, but in some instances, businesses have been known to act proactively in anticipation of future liabilities.

ECOVERING FROM BUSINESS FAILURE

Business failure is usually a demoralizing event in a person's life. It impacts both professional and personal self-esteem. Indeed, many experts believe that the entrepreneur who experiences a business failure goes through many of the same stages as individuals who suffer from the loss of a friend or loved one—shock, denial, anger, depression, and acceptance. But observers are quick to point out that people who experience business failure can still go on to lead rewarding professional lives, either as part of another company or—down the line—in another entrepreneurial venture.

Many analysts believe that chances of subsequent success in the business world often hinge on the entrepreneur's activities in the first year or two after the failure has occurred. The best response, after the initial shock has passed, is a realistic look at the reasons for the failure. This assessment, carried out by the individual with some help from uninvolved friends or mentors, may pinpoint the fatal turn which, if corrected, could lead in the future to a more successful run. For some, of course, the conclusion might be that life as an entrepreneur is not what they are seeking. Paul Hawken, a very successful small businessman and author of Growing A Business [Simon and Schuster, 1987], makes the important point that business is about problems; they cannot be avoided. The art of management is a knack for turning bad problems into good ones so that they stimulate creative responses—and new problems which challenge rather than overwhelm us.

SEE ALSO Bankruptcy; Liquidation

BIBLIOGRAPHY

"Are You Ready?" U.S. Small Business Administration. Available from http://www.sba.gov/starting_business/startup/areyouready.html. Accessed on 19 January 2006.

Business Enterprise U.S. Bureau of the Census. Available from www.census.gov/prod/2/gen/96statab/business.pdf. Accessed 19 January 2005.

Fairlie, Robert W. and Alicia Robb. "Families, Human Capital, and Small Business: Evidence from the Characteristics of Business Owners Survey." Center for Economic Studies. U.S. Census Bureau. September 2003.

"Firm Size Data." U.S. Small Business Administration. Available from http://www.sba.gov/advo/research/data.html. Accessed 19 January 2006.

Headd, Brian. "Business Success: Factors leading to surviving and closing successfully." Center for Economic Studies. U.S. Census Bureau. November 2000.

Hillstrom, Northern Lights

updated by Magee, ECDI