Why Young Companies Fail: What Studies Show About the First Years

What do young companies really fail because of?

Whoever founds or runs a young business gets a lot of advice on why others failed: wrong product, too little capital, poor planning, wrong partner. Each of these reasons occurs. But as a list they help little, because they do not say which mistake is dangerous in which situation.

This analysis therefore pursues the question: What does research show about why young companies fail in their first years, and what follows for founders and owners of young businesses?

To answer it, I first clarify what is meant by failure and introduce the oldest explanatory model, the liability of newness. Then I present two findings that make the model concrete and weigh whether failure lies more with the founders' mistakes or with the conditions. At the end there is a check for your own business.

What does failure mean, and why is the term difficult?

Studies usually do not measure failure but market exit: after a certain time, a company is no longer active. That includes insolvencies but also voluntary closures, sales, and cases in which someone takes a better-paid job. So not every exit is a failure. Conversely, there are businesses that keep running for years without paying their owner adequately. They count as survivors in the statistics.

For this article, failure therefore means: a business has to give up because it cannot cover its costs permanently or becomes insolvent. Where studies use the broader concept of exit, I say so.

Siren, Antretter, and colleagues (2020) reviewed research on the survival of young companies over 54 years. They show how many disciplines deal with it, from entrepreneurship research through management to sociology, and how differently survival is measured. That is one reason to read individual percentages with caution: they depend heavily on who counts as founded and who as exited.

The thinking model: the liability of newness

In 1965 the sociologist Arthur Stinchcombe published an observation that is still the starting point of research today: new organizations disappear more often than old ones. He called this the liability of newness. Aldrich and Yang (2012) summarize Stinchcombe's reasoning in three tasks at which young organizations can fail.

An everyday analogy: a new restaurant has the same kitchen as the long-established one across the street, but no regulars, no well-practiced service, and no supplier who will deliver on a Sunday in an emergency. It has to be better to do equally well.

Aldrich and Yang point to a limitation of many studies. They usually look at companies that are already registered and thus overlook the phase before, in which many start-up projects are already abandoned. The liability of newness may therefore be even greater than the figures on registered companies show.

Finding 1: the more that is new at once, the higher the risk

Shepherd, Douglas, and Shanley (2000) made the model manageable for founders. Their argument: the liability of newness depends on how much ignorance is associated with a venture. They distinguish three kinds of novelty. Novelty to the market means that customers do not yet know the offering. Novelty in technology means that the production or service process has not yet been tested. Novelty to management means that the founders have never managed such a task before.

A simple consideration follows: a venture that is new in all three areas carries a multiple of the risk of a venture that breaks new ground in only one. Whoever offers a familiar service in a new region and knows the industry from experience is taking less of a gamble than someone who brings a new product with a new process to market without industry experience.

A longitudinal study by Aspelund, Berg-Utby, and Skjevdal (2005) of 80 technology-based start-ups in Norway and Sweden fits this idea. It found that the resources at founding influenced survival. Founding teams with varied professional experience in different functions failed less often. The study concerns technology firms and a small sample, but it shows that missing management experience can be offset by a mixed team.

Finding 2: fluctuating revenue is a warning sign

The second finding concerns what is missing from many guides: money in everyday business. Lundmark, Coad, Frankish, and Storey (2020) analyzed the bank accounts of 6,578 young companies in the United Kingdom over ten years. The data come from customer records of Barclays Bank. This allowed the authors to measure something surveys do not capture: how strongly monthly revenue fluctuates.

The result is clear. Strong short-term revenue volatility was a strong indicator of later exit, even when many other influences were taken into account. The authors explain this through buffers: whoever has fluctuating income uses up their reserves in weak months and is more likely to run into payment difficulties. A second finding is remarkable. The surviving companies did not, on average, reduce their volatility. The fact that volatility fell in a cohort as a whole was mainly because the highly volatile companies exited more often.

For a young business, this is uncomfortable but useful news. Fluctuations do not grow out by themselves. Whoever does not actively reduce them, for instance through recurring services, more customers, or a buffer for several months, remains vulnerable. Why growth in particular strains liquidity is shown in the article growth costs liquidity. How dependence on individual customers can be measured is described in the article concentration risk with major customers.

Young businesses rarely fail because of one bad year. They fail because of three bad months for which there was no buffer.

Two readings: founders' mistakes or market conditions?

In public debate there are two readings of failure. The first holds the founders responsible: wrong assumptions about customers, too little planning, too little selling, too much optimism. In favor of this reading are findings such as that of Aspelund and colleagues, according to which the team's resources influence survival. The work of Shepherd and colleagues also suggests that founders steer their own risk through the choice of venture.

The second reading stresses the conditions. Young companies have structural disadvantages that have little to do with skill: no history with the bank, no references with customers, no practiced processes. On top of that come external shocks nobody foresees. Shepherd and colleagues name such shocks explicitly in the title of their work. From this perspective, part of failure is not incompetence but the flip side of a market in which many try and not all can succeed.

I consider both readings correct, but for different parts of the problem. The conditions explain why young companies have a higher risk in the first place. The founders' decisions explain why this risk turns out larger or smaller in the individual case. For the owner of a young business, the second half is the more useful one, because they can influence it. For judging a founder who has failed, the first half is the fairer one.

The Novelty Check: where is your business attempting too much at once?

A check can be derived from the findings that founders can use before starting and owners of young businesses in their first years. It combines the three kinds of novelty with the buffer against fluctuating revenue.

1. Rate novelty

   Rate from one to five how new the venture is to the market, in technology, and to management. From ten out of fifteen points, you are attempting a lot at once.

2. Reduce novelty

   Check where an area can be made more familiar: a pilot customer instead of a new market, a proven process instead of your own, an experienced partner in the team.

3. Measure volatility

   Enter the monthly revenue of the past twelve months and compare the weakest month with the average. If it is below half, volatility is high.

4. Define the buffer

   Determine how many months of fixed costs your reserve covers. Decide at which level you will counteract and how.

5. Reduce volatility

   Look for a route to recurring income, such as maintenance, service, or framework agreements, and spread revenue across more customers.

• No more than two of the three areas, market, technology, and management, are completely new to us.
• The team has experience in at least two different functions, such as sales and production.
• The weakest month of the past year was at least half of the average.
• Our reserve covers at least three months of fixed costs.
• No customer accounts for more than a quarter of revenue, or we are deliberately counteracting it.

What follows, and where are the limits?

Three conclusions can be drawn from the findings. First: the risk of young companies cannot be eliminated, but it can be distributed. Whoever breaks new ground in only one area gains time to learn there. Second: liquidity is not a topic for later. The British bank data show that fluctuations are a stronger warning sign than many think and that they do not resolve themselves. Third: in the first years, selling is the owner's job. How founders build sales so that it does not depend on them later is described in the article founder-led sales.

The limits belong here as well. The studies come from the United Kingdom, Scandinavia, and international research, not from Germany. They show associations, not established causes. Official figures on the survival of newly founded companies in Germany are published by the Federal Statistical Office; they are not reproduced here because they vary considerably depending on how firms are delineated. And the best preparation does not protect against an external shock. How businesses build resilience is covered in the article business resilience.

Conclusion: why do young companies fail?

The question at the start was
research shows about the failure of young companies and what follows from it. The answer is sober. Young companies carry a structural liability of newness that has nothing to do with incompetence. The risk rises the more that is new at the same time, and in everyday business it shows above all in strongly fluctuating revenue that eats up reserves. A single big mistake is less often the cause than the sum of too much novelty and too little buffer.

For founders and owners of young businesses, this yields a sequence: limit novelty, bring experience into the team, measure volatility, and build a buffer before growth begins. For this week, the first step of the Novelty Check and a look at last year's monthly revenue are enough.

Whoever knows what is new about their venture can decide where to carry the risk. Whoever does not know carries it everywhere.