Reasons for early-stage venture failure

Research notes 2011 on the literature regarding reasons for failure in early stage companies (partial). A revision of this is in progress.

A clear distinction is required between failure due to the individual entrepreneur and that attributable to the venture itself (Gulst and Maritz 2009). In the table below, a number of causes of new venture failure are presented, along with a commentary on these causes.

Reason for failure Commentary
(Missing) entrepreneurial characteristics Risk of venture failure is higher when entrepreneurial characteristics are absent.
Over-confidence Entrepreneurs consistently perceive their chances of success as being significantly higher than those of comparable companies.
Novelty In the absence of established market, sector or product, new ventures struggle to define a clear new value proposition.
Product design First mover advantage requires a trade-off between early availability and product readiness – going to market too early may be damaging.
Opportunity evaluation Is it worthwhile to proceed with the venture? Inadequate qualification of the opportunity is a frequent explanation for failure.
Product Newness There is inherent risk in terms of stability, acceptance and trust by customers in a new venture.
(Bad) timing Product readiness has to coincide with market readiness.
Rapid growth Customer adoption rates may exceed a venture’s ability to absorb, process and support new customers.

Table 1. Causes of New Venture Failure (Gulst and Maritz 2009)

Lack of preparation is considered by Matherne, who evaluates whether early stage ventures are better “doing” than “planning” (Matherne 2007). Given the hands-on ethos of young companies, consuming precious resources on business planning may appear unnecessary. However, other writers (Delmar and Shane 2003) suggest entrepreneurs receive great value from the planning process, which in turn reduces the risk of business failure.

Thornhill and Amit, in their review of 339 Canadian bankruptcies, highlight differing reasons for failure in mature and young companies. They find that “failure among younger firms may be attributable to deficiencies in managerial knowledge and financial management abilities. Failure among older firms, on the other hand, may be attributable to an inability to adapt to environmental change.” (Thornhill and Amit 2003: 498). They take a Resource-Based View (RBV), suggesting termination is conceptually due to an exhaustion of their initial resources or “internal asset stocks.” However, this fails to account for non-financial resources in early stage companies: for example, the “upside” associated with stock options may play a psychologically greater role than other financial incentives. The level of enthusiasm, focus and skill conveyed by founders of early-stage firms may persuade initial customers, investors and partners to overcome the liability of newness and sign deals with such a firm.

Some writers point to the importance of language in analysis of failure. Meta-definitions are needed to define who was “at fault”, who was “to blame”, and what were the “underlying causes” (Cope and Cave 2008). The use of ‘blame’ and ‘fault’ implies value judgment in the evaluation of failed ventures. This may help explain why phenomenological approaches have yielded valuable results. Culture and language are also essential factors in any comparative study where feelings, opinions and viewpoints may be impacted by language barriers.

In Pretorius’ examination of many reasons for failure (Pretorius 2008), he distinguishes between causes and preconditions. In his analysis, these causes may be characterized thus: human causes; internal or external; structural; or financial. Human causes of failure provide a rich variety of considerations including the five stages of decline (Weitzel and Jonsson 1991): the blinded stage; the inaction stage; the faulty action and faulty implementation stage; the crisis stage; and the dissolution stage.  Internal and external causes may be represented as either controllable or non-controllable factors: a study of Singaporean small businesses (Theng and Boon 1996) found that endogenous factors were significantly more likely to cause failure than external issues. Structural causes vary according to several dimensions: age, size, maturity and possibly the “liability of newness”. Financial causes are possibly the easiest to measure: corporate financial data enables rich analysis of the current and predicted health of new ventures, although technology startups tend to be privately held.

Garnsey and Heffernan studied “growth setbacks” in their longitudinal study of UK high tech firms (Garnsey and Heffernan 2005). This is reflected in what Pretorius calls the “turnaround” activity (Pretorius 2009). Companies that recover have difficulty doing so alone, and remain vulnerable: continual support from investors, customers, suppliers and employees may be required for business continuity. “It takes only minor perturbations to block the inflow of resources in irrecoverable ways” (Garnsey and Heffernan 2005: 691). Another longitudinal analysis of UK survival of 622 small firms including 71% which may be considered early-stage (Saridakis et al. 2008), concludes that educational background of the founders and the level of bank finance are primary indicators of failure or survival.

Larson and Clute suggests three reasons for small-business failure: personal characteristics; managerial deficiencies; and financial shortcomings (Larson and Clute 1979). These reasons become critical at certain ‘inflection points’: one such point is the Founder-CEO succession period, representing a shift in culture, experience, process and personalities (Wasserman 2003). Two other critical stages occur when initial product development is complete and when the first funding round is secured: both representing dangerous failure points for young ventures.

In early-stage firms, the “liability of newness” and the “liability of smallness” may be critical (Zacharakis et al. 1999). The liability of newness addresses the team, technology, market and investors, individually and in combination. The liability of smallness adds another dimension: as young firms emerge with products and customers and start to grow, there is often an “executive limit” (Zacharakis et al. 1999) to when and how this growth may occur. Shepherd and others also scrutinize the liability of newness. They suggest three main issues are at play: the novelty to the market, novelty of production and novelty to management (Shepherd et al. 2000). They conclude: “the decline in mortality risk occurs as the venture’s novelty in each of the three dimensions is eroded by information search and dissemination processes.” (Shepherd et al. 2000: 394).

In the Dominican Republic, Alvarez, et al. examine the lifecycle of new businesses as motivations and intentions of founders evolve (De Castro et al. 1997). Like other studies (Stokes and Blackburn 2001), they suggest that business failure is only one reason for business closure: others include retirement, identification of better alternatives and achievement of original goals. Alvarez applies three theoretical lenses to review this: (1) strategic choice theory, where business closure may be a discretionary choice made by founders; (2) organizational equilibrium theory whereby closure may reflect alternative options for participants; and (3) efficiency wage theory, where rational employees may pursue better salaries elsewhere.

Garnsey and others provide a holistic view of failure in new firms. Basing their approach on the work of Edith Penrose (Penrose 1995), Garnsey et al. identify five area of interest: patterns of survival, continuousness of growth, turning points, reversals and cumulative growth. Their conclusion is that “New firm growth is not indeterminate but, like other complex dynamic processes, the outcome of systemic feedback mechanisms, the effects of which may be mistaken for randomness when statistical methods are used that cannot capture the subtleties of causal feedback.” (Garnsey et al. 2006: 18). This echoes Casson’s work on the impact of “shocks” to early-stage companies (Casson 2005).

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About Keith Cotterill

After 25 years in finance and technology, I have returned to university to read for a doctorate at Cambridge. I am an active technology entrepreneur and investor as well as a researcher and divide my time between the UK and Silicon Valley.

Posted on July 24, 2011, in Entrepreneurship, Failure Rates, Startups. Bookmark the permalink. Leave a comment.

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