Types of Business Failures and Its Causes?

Business failures with startups and small size entities are common. Broadly speaking there can be several types of business failures and reasons causing such it. Financial accountants often term liquidity crunch more fatal than profitability for settled businesses. New business startups may fail due to inadequate planning and insufficient resources.

What is Business Failure?

We can define it as the inability of a business to achieve its objectives. Every business sets its vision and mission statements. It defines the business goals and objectives. If a business fails to achieve these objectives, we term it as a business failure. The objective can be financial or non-financial terms.

Generally, it relates to financial failure. A business may go through liquidity crises, go insolvent against debtors, and become bankrupt. However, even a bankrupt business may be able to restart or restructure. A failed business usually ends up winding the business.

Three Types of Business Failures

We can broadly categorize into three types. Much like business risks as internal and external factors. Some of these types can be avoided and some become inevitable for the business.

Preventable Business Failures

One of the 3 types of business failure is preventable business failures. Any failure that management could foresee and avoid is preventable. For example, management may have predicted lower seasonal sales that resulted in non-compliance with debt repayment. A new product launch without proper market research. Technological advances by the competitors that the management could analyze and embed in the business.

Financial metrics and ratios are interpreted to analyze historic performances and predict the future situation. A company may fail due to misinterpretation of key financial indicators such as liquidity and profit margins.

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It relates to management’s inability or incompetency. Either way, shareholders can hold the company management responsible for such type of failures.

Unavoidable or Complex Business Failures

It is another broad type of business failure among the 3 types. As the name suggests, such failures occur due to unavoidable factors for the operation. Macroeconomic factors play a fatal role in such failures. These failure types are often difficult to predict. Economic factors such as political instability, recessions, and wars contribute towards such business failures.

Some macroeconomic business risks can be predicted. These risks cannot be avoided by businesses but mitigated. Competent management can plan for risk avoidance and mitigating effects to keep the business afloat.

Intellectual Business Failures

 It is another type of business failure among the 3 types. Precisely speaking these failures relate to business strategies. Intellectual failures mean a failure to strategize or research on business development. For example, a business may spend the bulk of resources on innovating new technology but fail to achieve the results. A new product launch that results in failure due to lack of planning.

These failures are common among tech-based companies. Such failures arise due to experimenting and innovative projects without experience.

Causes of Business Failures

There are no simple or calculated measures on what causes such failure. Internal and external risks, lack of innovation, poor marketing, lack of financial resources, etc. are some of the common reasons for business failures. By the nature of a failure, there are unlimited numbers of reasons for a business failure. From incorporating a business structure to registration and legal patents, to financial management.

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Broadly we can categorize business failure causes internal and external causes.

Internal Causes

  • Lack of Financial and management resources. Inadequate startup investment and lack of business management skills.
  • Poor strategic business planning with vague objectives and undefined business goals
  •  Lack of innovation and limited research and development efforts
  • Failure to market the products/services properly
  • Imbalanced finance structure. Excessive equity or excessive debt financing.
  • Inadequate risk management resources and internal controls
  • Informal business structure
  • Complacent or compromised management

External Causes

  • Macroeconomic risks such as economic recessions, political instability, and war
  • New competitors entry with distinctive technological advantages
  • Legal and compliance issues resulting in a business wind-up
  • Unrealistic shareholders’ expectations resulting in business liquidation
  • Social or community issues resulting in business insolvency

It is pertinent to mention that business management can only control internal risks causing business failures. External risks resulting in such failures cannot be controlled by the management. However, effective internal control and risk management do take into account both internal and external risks.

A failed business passes through insolvency and sometimes bankruptcy processes. An insolvent business may find financial support and restructure. A bankruptcy usually ends up in winding up a business. Some bankruptcy situations may result in restructuring if the business possesses significant assets after settlements with creditors.

Voluntary Settlement

A business windup may take several legal forms. A settlement comes as the last resort of an insolvent and bankrupt business. The settlement needs to take place on business assets and importantly on liabilities towards shareholders and creditors.

A voluntary settlement occurs when business shareholders and creditors settle the liabilities out of the court jurisdictions. Bankruptcy and judicial settlements often come with high costs, bad reputation, and complexities. Shareholders would want to avoid any bankruptcy if they possess sufficient assets. For small businesses, a voluntary settlement can save business owners’ personal lien and assets pledged for financing.

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Why Voluntary Settlement is a Better Option?

Voluntary settlement may be the best option if the business still has valuable assets intact. Creditors will be primarily concerned with recovering debts with interest charges without spending on legal matters. The shareholders and management would want to save their reputation and personal liabilities. In the case of a subsidiary, group shareholders would take bankruptcy as a bad reputation mark for the group shareholding as a whole.

Stakeholders prefer a voluntary settlement for several advantages:

  • It avoids bad publicity, especially for a group of companies.
  • Fewer complications and lower legal costs
  • Creditors and shareholders alike can arrange the final liquidation of assets
  • The management will prefer a voluntary settlement as a career-saving move

Small companies and subsidiaries may achieve the objectives of incorporation. A subsidiary company is often set up for a limited period with a precise objective. Once the business achieves these objectives, a voluntary settlement may suit all stakeholders.

However, in case of large business entities liable to creditors for large loans, it may not present an ideal situation. Regulatory and tax authorities may not allow for an out-of-court settlement without legal proceedings.

A Quick Wrap-Up

Business failures may result due to internal and external risks. Controllable and uncontrollable factors contribute alike to business failure. Efficient and skillful management can mitigate and manage preventable causes. In the case of such failure, a voluntary settlement presents an out-of-court arrangement between the business creditors and the business.

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