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Why Small Business Failure Rates are Declining

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Hidden in much of the gloomy news about small business in recent years is an important positive statistic: business failure rates are in a long-term decline. The rate at which American employers go under has fallen by 30 percent since 1977.

Sure, the trend is far from perfectly linear. Business failure rates rise in recessions and decline in expansions. But the underlying trend is there. A smaller fraction of companies goes under every year now than three decades ago.

Economists are not sure why, but I think five factors are central: A shift of small business to more favorable sectors of the economy; less competition from new entrants; fewer marginal businesses being formed; smarter small business owners, and better business-management technology.

Part of the decline in the business failure rates stems from a change in where small businesses operate. As the industry mix of small companies has shifted away from sectors like construction, where failure rates are higher, to sectors like services, where closure rates are lower, the average rate of business survival has risen.

Another factor is the decrease in new business creation. Census Bureau data show that the new company share of employers declined 51 percent from 1977 to 2013.

While many people decry this trend, it's good for existing companies. If fewer new businesses are being started then existing companies face less competition. With fewer new businesses trying to get capital employees and customers, existing small business owners have easier access those resources, boosting the odds of their survival.

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A third factor is the tendency of would-be entrepreneurs to evaluate business opportunities more carefully before taking the plunge. Potential company founders are more selective than they used to be. This means fewer marginal companies – businesses whose products are not needed or whose markets are already being served by other businesses – are being formed. As a result, the average American company is stronger and more likely to survive than it once was.

A fourth factor is improved small business management talent. Small business owners today are better at managing their businesses than their counterparts were 35 years ago. They are better educated and are more likely to have studied business in school. Moreover, the growth of the Internet and the popularization of academic research has exposed more small business owners to knowledge about how to run a business effectively.

A final factor is technology. Small business owners today have access to better technology to help them operate their companies than those in business for themselves had 30-plus years ago. Today's small business owners have computers, point-of-sale terminals, inventory and financial management software, and many other tools that weren't available three decades ago. These tools make them both more efficient and more effective at managing their companies. As a result, a smaller fraction of company owners are making business-ending mistakes today than did so 35 years ago.

Business failure rates clearly fluctuate with the business cycles. More companies go under in recessions than expansions. But over the past three-and-a-half decades, company closure rates have trended down. Movement of small companies into more favorable sectors of the economy, less competition from new entrants, a more selective approach to business formation, better managers and improved technology are the key factors driving these improved business survival rates.

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