Creating Wealth with a Small Business: Strategies and Models for Entrepreneurs in the 2010S

By Ralph Blanchard

A must-read book filled with practical information and numerous case studies on what aspiring entrepreneurs and business owners need to know to run a profitable businessthe author reminds the reader not to confuse the excitement and enthusiasm of starting a business and being a business owner with the skills required to be successful and avoid becoming one of the 80% of businesses that will eventually fail. A major contribution of this book is its continuous emphasis on the importance of having a business model as a critical requirement to start and manage a profitable business.

Edgar Ortiz, CEO of Strategic Analytic Solutions and business columnist for the Atlanta Journal-Constitution Ralph Blanchard, a successful entrepreneur with a background in economics, provides a detailed analysis of what it is really like to buy, start, operate, and eventually sell a small business. Topics covered include: why most businesses fail ten management skills found in successful small business owners strategies to transition from self-employment to entrepreneurship advantages that small business owners have over larger competitors tips to develop profitable pricing strategies innovative ideas to help develop a sound business model

• Language: English
• Publisher: iUniverse
• Release date: Aug 3, 2011
• ISBN: 9781462029228

Ralph Blanchard

RALPH BLANCHARD earned a BA from Cornell University and a PhD from Binghamton University. He taught undergraduate economics and environmental policy courses and spent seven years with a Fortune 500 company as National Training Director before starting and then selling a series of small manufacturing and information-based service companies.

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Contents

Foreword to the 2010’s Edition

Chapter One

Why Some Small Businesses Succeed

Chapter Two

Ten Management Skills Found in Successful Small Business Owners

Chapter Three

The Self-Employment Trap

Chapter Four

Small is Beautiful

Chapter Five

Small Business Models

Addendum to Chapter Five - Small Business Models A Case Study of the Bostrom Company:

A Small Business That Failed

Chapter Six

Pricing Strategies for Products and Services

Chapter Seven

A Pricing Strategy for Selling Your Business

Chapter Eight

Small Business Opportunities after the Great Recession

Appendix

Cash Flow and Accounting During the Start-Up Phase

Foreword to the 2010’s Edition

Although I had always planned to update the 2009 edition of Creating Wealth with a Small Business, I had no idea that a major revision would be needed so soon. But from early 2009 (when the book was first released) to mid-2011 (when I am completing work on the 2010’s edition) the economy has undergone a series of wrenching changes that have impacted businesses of all sizes, destroying vast amounts of personal wealth in the process. This has not been limited to the United States; the crisis is global. Moreover, the end is not yet in sight. Federal, state and local governments in the U.S., the U.K. and the Euro zone are only just now beginning to feel the full effects of the economic decline. Austere public budgets and sharp reductions in government spending are expected to exert further downward pressure on the global economy. The next few years could be every bit as volatile as the last two. The small business owner/entrepreneur caught up in this cascading chain of economic disasters is under stress in ways unimaginable just a couple of years ago. The economic boom years are over; entrepreneurs are going to have to make adjustments if they are to thrive in an extremely unpredictable economy.

I was well aware that significant problems were beginning to affect the economy in late 2008 when the first edition was ready for release. In fact, publication was delayed briefly while I updated parts of the manuscript. The Epilog Can Small Business Start-ups Survive during a Financial Panic or Recession was added in order to address issues related to the growing financial crisis being reported in the news. Lehman Brothers had declared bankruptcy on September 15, 2008 and large parts of the banking system suddenly seemed on the brink of collapse. Henry Paulson, then-President George Bush’s Treasury Secretary, was launching TARP (the Targeted Asset Relief Program). He had the backing of prominent economists and political leaders, most of whom supported significant government intervention intended to prop up the existing financial system by purchasing failed assets from major investment banks and injecting liquidity into the national and global banking systems. But even as I scrambled to move my personal wealth into safer harbors I, like so many others, did not clearly see the depth of the crisis that was unfolding and especially how it might impact entrepreneurship and small business. We have had several recessions and financial bubbles in my lifetime, each of which proved to be temporary and manageable. I assumed that as with prior crises massive government intervention would limit the damage and the economic order would be restored in a reasonably short time. My parting advice to my 2009 edition readers was that entrepreneurs usually remember challenging and volatile times as the best of times and that an economic crisis is no exception, the implication being that the financial meltdown might in some ways turn out to be a positive learning experience for everyone involved. It is unclear how much we have learned, but one thing is certain: it hasn’t been a positive experience.

For those of you who did not read the 2009 edition of Creating Wealth it might be helpful to offer some background and briefly describe my original reasons for writing the book. Prior to the collapse and its aftermath (which economists now call the Great Recession), the global economy was caught up in what Alan Greenspan famously described as irrational exuberance. There was a feeling that America had entered an era of limitless economic growth with unprecedented opportunity for innovation, profit and professional self-fulfillment. It was not unreasonable, so the experts advised, for anyone to expect to become wealthy if they were willing to unleash their animal spirits and take on at least some modest degree of financial risk. The credit for this miracle was generally given to free markets fueled by cheap, readily-available money and operating with minimum government intervention and oversight. In this wild-west economy risk was wise, caution foolish. Stock portfolios and home equity values soared while returns on more traditional modes of savings and investment lagged behind. Sequestering liquid assets in a money market account or a conservative bond fund seemed downright cowardly.

An atmosphere of irrational exuberance, which peaked in the 2006 – 2007, had far-reaching implications for attitudes toward business start-ups. The watchwords in the popular business press were entrepreneurship and innovation. Small-business consultants and franchisers emphasized the tremendous potential in starting, owning and operating a new business if you would just follow your dream. Successful business owners became national heroes with their celebrity lifestyles providing fodder for the talking heads on entertainment TV. Success stories like the Google start-up fueled the imagination of tens of thousands of wannabe entrepreneurs. Banks were eager to grant home equity loans or increase the debt ceiling on credit cards for new business owners. The pathway to success seemed simple: start a business based on something you feel passionate about, make millions either through direct ownership or a successful IPO (Initial Public Offering) and then retire young and rich so you could devote the rest of your life to further business investment, philanthropy or community leadership and service. It was the American Dream writ large and was open to anyone with the courage and foresight to become an entrepreneur.

I was (and still am) a believer in entrepreneurship. After a corporate career with a Fortune 500® company I started a series of small businesses over a 25-year period and was reasonably successful each time. In 1987 I launched a business start-up that grew to the point where I franchised its business model and thus was able to observe first-hand the hopes and dreams of potential small business owners seeking success and financial independence. In many cases I served as their facilitator. At times it was as exhilarating for me as it was for them. But there was a dark side even as the economy boomed in the years prior to the Great Recession. It was clear to me that many people wanting to start businesses, though highly motivated, lacked a workable business model, completely misunderstood the financial skills (to say nothing of the capital requirements) needed for starting or running a business, did not have the necessary work ethic and had not yet developed the management skills needed for success in what had become a hyper-competitive, global economy. Some of my friends and acquaintances were successful entrepreneurs and had made money, but I also knew of many who had failed. The consequences were often financially and psychologically devastating both for themselves and their families. My research on business start-ups confirmed these observations: the data showed that the failure rate of small business startups exceeded 80% even during the best of economic times. The failure formula was usually the same: a feel good business launched on a wing and a prayer with the venture relying more on enthusiasm than anything else. Few lasted more than a year or two.

It was in this business environment that I decided to write a book drawing on my experience and outlining the main elements of what I had observed to be a small business success formula. The failure rate could be reduced significantly, I argued, if some basic small business principles were observed. I felt that successful entrepreneurship required (1) a sound business model that would present customers with a persuasive value proposition, (2) carefully-planned pricing tactics that placed profit ahead of volume, (3) a clear understanding of the advantages and disadvantages of small businesses vs. large business and (4) a well-thought-out exit strategy that would enable the owner to extract the wealth created by a successful small business. To help novice entrepreneurs understand the overall process, I included brief anecdotes and multiple, detailed case studies that illustrated both successful and unsuccessful start-ups. Many of these strategies had to be developed long before the business was actually launched so that advanced planning and preparation were critically important. I envisioned my book becoming a resource to be used both during the planning stages and then again later on when it was time for the entrepreneur to sell the business. Throughout it all I tried to warn those thinking about starting a business that careful planning and precision execution were not nearly as much fun as getting excited and jumping into a project with abandon. The odds of success, however, would be much greater.

How much of my original success formula makes sense given the current state of the economy? After a thoughtful rereading of the strategies and tactics proposed in the 2009 edition of my book I would say that, despite the changes caused by the recession, much of the advice remains sound. The modeling, pricing and buy/sell strategies are more important than ever, and the discussion of management skills development is still highly relevant. However, although we don’t have a clear picture of the overall level of entrepreneurial activity at the moment (reliable small business data on start-ups and failures over the past couple of years is not yet available), anyone who visits a strip mall or business park or talks with a small business owner can see that there has been a dramatic reduction in small business activity. It is not clear that that the number of new start-up attempts has declined significantly but there is ample evidence that franchise sales (a traditional path to business ownership for many entrepreneurs) have stalled. A major concern I had as I wrote the 2009 edition was excessive risk-taking by entrepreneurs who were poorly prepared for the realities of business ownership. This is not the situation today. The psychology of entrepreneurship has been reversed: even modest risk is now considered too risky and entrepreneurs exercise extreme caution in launching start-ups. The sections in my 2009 edition that dwell on the dangers of entrepreneurship are less relevant and only add to the prevailing gloom. Therefore, they have been rewritten to draw attention to the new kinds of emergent opportunities (and there are some good ones) for entrepreneurs who seek to forge ahead even in the face of a weak economy and a depressed (and depressing) business climate.

What is the best way to use this book? That depends upon what stage you have reached in your career as an entrepreneur. It does not have to be read end-to-end like a novel. There is no dramatic concluding chapter that gathers all of the book’s highlights into one brilliant paragraph. As with the earlier edition, I suggest you pick and choose after consulting the Table of Contents, reading relevant chapters or sections now and saving others for later when you have the time and the interest or the need. My hope is that this revised edition of Creating Wealth will continue to serve as a guidebook for small business entrepreneurs over the next few years when the risks are greatest and the rewards seem least likely. The fact is that in these circumstances those who seize the first-mover advantage will be the ones who prosper most as the economy recovers. Despite all of the economic problems we face, I remain committed to the idea that the best pathway to individual wealth and the American Dream is ownership of a successful small business. The current post-recessionary period is not the time to be sitting on the sidelines.

I would like to add some comments on feedback I received on the 2009 edition from readers and reviewers. First of all, thank you. The reviews were 98% positive and reader response, though sometimes critical, has been very helpful. What pleased me the most was that readers and reviewers alike were able to sense my street-level experience dealing with the real-world problems of small business ownership. They appreciated the anecdotes used to illustrate many of my points and so I have kept most of them so as to maintain what one reviewer called a you are there perspective throughout the book. An underlying theme in these anecdotes is that small business happens in the street, not in an academic seminar or a C-suite conference room 40 floors up. The comments I received also placed value on my willingness to explore and explain failure in business and to realistically project the relatively slim odds of success when starting a business and the losses and collateral damage that occur when a business fails. It isn’t all wine and roses, especially in the early going, and the sooner a new entrepreneur realizes that, the better. The Appendix entitled Cash Flow and Accounting for Small Businesses During the Start-up Phase was appreciated by all and remains intact in the second edition. So too do the case studies, although some readers found these tedious because of what they considered an excessive amount of detail. In reality, a lot of the original detail was left out to make these studies more readable. In my opinion, if details overwhelm you or reading about business bores you, you probably should not start your own business. The entrepreneur’s daily life can be infinitely complex and the stress can quickly turn your dream into a nightmare. To be successful you need to be learning new things every day and living and breathing business 24/7/365. If this not what you have in mind, get a job working for someone else. Another point: I continue to refer to everyone in the book as he or him instead of he/she or perhaps his/hers. Some complained about this so I want to make it clear that this is for my convenience only. Women are every bit the equal of men when it comes to entrepreneurship and the glass ceiling that limits most women to lower-level positions paying lower-level salaries in large corporations simply does not exist in the world of privately-owned small business. More women should take advantage of this fact. I also received mixed comments about the large number of footnotes which some readers found distracting. I was criticized for not using footnotes in a previous book on digital technology and perhaps overcompensated in this one. After a thorough review I have eliminated some footnotes and reduced the length of others but I have concluded that those remaining (plus a few new ones I have added) will be useful to most readers. The footnotes stay.

To all who reviewed, replied or offered comments, I am very grateful for your time and attention. This revised edition is better because of your input.

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I would like to thank Miss Donna (a/k/a The Lovely Miss Donna) for supporting this project with her business and editorial expertise. As was the case with the first edition, her suggestions were extremely helpful and her encouragement invaluable. I couldn’t do it without her. I trust she knows that.

I also want to thank Paz the Cat, a truly beautiful creature whose calming presence can be felt whenever she is close by. She will always have a big, round bed on my desk.

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Questions, comments and suggestions may be sent to [e-mail] or posted on http://smallbizwealth.blogspot.com/.

Chapter One

Why Some Small Businesses Succeed

America leads the world in the creation of individual wealth. One reason for this is that America also leads the world in the formation of new businesses. Contrary to what we might expect, it appears that the number of new businesses being formed in the U.S. has not decreased during the recent economic slowdown. Business failure rates are extremely high, however, and so there is substantial personal risk involved in becoming an entrepreneur. What causes businesses to fail and what motivates entrepreneurs to take risks? What can entrepreneurs do to improve their chances of success in a weak economy? To answer these questions entrepreneurs need to begin by rethinking much of the conventional wisdom that has traditionally guided small business owners. In addition, it is also important for entrepreneurs to develop Core Values and General Principles as a basis for strategic planning and management decisions in a rapidly changing business environment. Chapter One explores these issues and also presents a case study of a small business that failed during the Great Recession that began in 2008. Did it fail because of the recession or were there other problems that led to the collapse? Understanding why businesses fail can help entrepreneurs understand why some small businesses succeed.

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At the end of 2009, approximately 10 million individuals in the world had cash (liquid) assets of one million dollars or more.¹ This was the most millionaires since 2007 and reflects the improving finances of HNWIs (High Net Worth Individuals) now that the Great Recession is officially over. Aggregate global GDP (Gross Domestic Product, a standard measurement of economic activity) actually contracted 2% in 2009, but HNWI financial assets grew 18.9% to $39 trillion. This represents about 35.5% of total global wealth. The U.S. had the largest number of HNWIs (2,860,000 or 28.6% of the global HNMI population). They had assets of about $10.7 trillion. Despite the slow recovery from the recession, the number of HNWIs in the U.S. increased by 406,000 in 2009. (By comparison, China, with a population six times greater than the U.S., had about 1.1 million millionaires at the end of 2010.) America has continued to generate great wealth even during the worst economic downturn since the 1930’s.

How do HNWIs accumulate their wealth? Globally, approximately 14% are full-time investors with financial portfolios and real estate holdings, 16% receive inheritances, and 23% hold down a job, usually as a high-end executive or skilled professional. The rest, 47% of the total HNMI population, own private businesses. In the U.S. the percentage of business owners is even higher, approximately 66%. Add to that number those who inherit wealth or accumulate it from investments and you soon realize that only a small number of Americans become millionaires working for someone else. Most of them own businesses.

Who Wants to be a Millionaire?

Is it important to have $1M? Most Americans today probably think so although this has not always been the case. In the 1950’s a popular TV drama called The Millionaire conveyed the message that having $1M was not necessarily a good thing. The show was fictional but bore a strong resemblance to present-day reality TV. Each week a philanthropist named John Beresford Tipton, Jr., selected individuals seemingly at random and gave them a cashier’s check for $1M. There were no obligations and no strings attached. There weren’t even any taxes due (Mr. Tipton paid them in advance). The lucky recipients were free to do as they pleased with the money. Not surprisingly, things often went badly as wealth proved to be a mixed blessing. The weekly lesson for Mr. Tipton (and the TV audience) was that coping with great wealth can change people. It undermines their sense of self-worth, destroys friendships, causes them to lose the respect of their peers and sometimes even costs them their lives.² The Millionaire struck a responsive chord in American culture, airing for five years (1955-1960) and lasting two decades in syndicated re-runs.

Fast-forward to today and we would probably consider the sudden gift of $1M unbelievably good luck. One of the most popular TV game shows in recent years is Who Wants to be a Millionaire? It offers contestants a chance to win up to $1M by correctly answering a complex series of questions. Neither the audience nor the lucky winners have any misgivings about somebody becoming a millionaire. Moreover, Americans are not the only fans of wealth. Millionaire fever has gripped global audiences and Who Wants to be a Millionaire? has franchises in over 100 countries. In 2008 the movie Slumdog Millionaire was based on the fictional life of a contestant in the Indian version of Who Wants to be a Millionaire? As the contestant (a young boy from an unimaginably poor background) gets closer to winning the top prize, he is accused by the authorities of cheating simply because he is doing so well on the show. They cannot believe that someone of his lowly upbringing is answering the questions correctly and stands to win such a large sum of money. Of course the movie audience sides with the slumdog, who they realize would never have the chance to lead a normal life (to say nothing of becoming a HNWI) unless he wins the top prize. The moral of the story is that everyone has it within himself to be a millionaire (even if the only way to become one is to win the top prize on a game show). Written by an Indian author and filmed in the slums of Mumbai, the movie was a huge hit globally and won eight Academy Awards in the U.S.

It is clear that attitudes toward wealth have changed since the 1950’s. The cautionary tales of The Millionaire have given way to legions of Who Wants to be a Millionaire fans cheering on great wealth and hoping for their own chance to strike it rich. Although there are nagging issues concerning the growing concentration of wealth in the U.S., most Americans today would accept a gift (or a lottery prize) of $1M without a second thought. There is a sense that millionaires are an acceptable, and perhaps even inevitable, result of capitalism and a free market economy. The opportunity to become wealthy is there for anyone who sees it. Millionaire fever is not a disease - it is a calling.³

What explains our changed attitudes toward wealth? First of all, the effect of inflation over several decades has made what used to be a large amount of money seem small. Mr. Tipton would have to give away $8M today to have the same impact that $1M had in 1955. Put differently, $1M in 1955 dollars is worth only $110,000 in 2010. Eight million dollars is serious money for most people. One hundred thousand dollars is a lot of money but hardly qualifies as the kind of wealth that alters lives forever.

Second, thanks to the magic of modern consumer credit, a person can live a millionaire’s lifestyle even if they have no net assets. An American with a good credit score can enjoy a much higher standard of living than even a real HNWI living in a third-world country. Bona fide millionaires may be rare, but we see people living like millionaires all around us. All they have to do is make their monthly payments on time. Unfortunately, with the onset of high unemployment caused by the Great Recession, keeping up with payments due on mortgage and credit card debt has become difficult, if not impossible, for many Americans living on revolving credit.⁴ Personal bankruptcies have soared and foreclosures have forced millions out of their homes. The lesson learned is that one is better off actually having $1M than using easy credit to create the illusion of being a millionaire.

A third factor in changing attitudes toward wealth has been brought about by the slow but steady fraying of the economic safety net that most Americans had come to count on to sustain them during their working and retirement years. Not only has unemployment increased dramatically and job security become more tenuous, but wage growth has also stagnated. In addition, many non-wage benefits such as health insurance and retirement plans are being reduced. Many employers no longer provide health insurance and many who do require employees to shoulder more of the costs (through higher deductibles, for example). This comes at a time when health cost increases have far exceeded the rate of inflation. Retirement has also become less secure. In 1980, 66% of American workers had defined benefits pension plans. Thirty years later that number has declined to 20%. Even union contracts provide poor defense against a restructuring of wages and benefits. Worst of all, Social Security and Medicare, programs that have become the bedrock of economic security for almost all Americans, are said to be in financial trouble. Increases in worker and employer contributions are being phased in and consideration is being given to reductions in benefits. Increasingly, Americans have to face up to the fact that there may be insufficient wealth in our society to allow everyone to live like a millionaire. If you want financial security, you are on your own.

Why Own a Business?

If the HNWI numbers tell us anything it is that much more wealth is created through business ownership than through any other investment strategy or employment opportunity. This is true not just in America but around the globe. This helps explain the tremendous interest in entrepreneurship that has gripped the imagination of people everywhere over the past thirty years. Starting in the 1970’s the great promise of capitalism has been the opportunity to own a business. No one has responded more enthusiastically than Americans. At the peak of the Greenspan Bubble (2006-2007) as many as 2,500 new businesses were being started every day in the U.S., between 50,000 and 60,000 each month. We might expect that the number of start-ups has declined with the onset of the Great Recession, but according to the Kauffman Foundation, a nonprofit dedicated to business education and the encouragement of entrepreneurship, this does not appear to be the case. An in-depth study undertaken to explore patterns of new business start-ups found that the number of start-ups remains steady whether the economy is expanding or contracting:

Firm formation in the United States is remarkably constant over time, with the number of new companies varying little from year to year. This remains true despite sharp changes in economic conditions and markets, and longer-cycle changes in population and education. Such constancy possibly reflects the nature of the United States economy, employment churn, and demographics. A steady level of firm formation implies that relatively few factors, such as entrepreneurship education and venture capital, influence the pace of startups….⁵

Why do entrepreneurs continue to start new businesses even during difficult economic times? The Kauffman study suggests several possible explanations. The most obvious is that new business formation is a reaction to high unemployment. While many nascent entrepreneurs (those thinking about starting a business) are frightened by an economic slowdown and decide not to start a new business, higher unemployment forces more workers into self-employment and many of these self-employeds ultimately form new companies.⁶ People start businesses because they have lost their job and need an income to survive. The Kauffman study also suggests that during an economic downturn there is heightened ‘opportunity recognition’ by under-employed or unemployed entrepreneurial talent (Kauffman’s term) who seek greater control over their financial future, something that employers fail to provide when the economy deteriorates.

A third factor highlighted by the Kauffman study has to do with planning. Relying on a detailed business plan or a business model that has benefitted from the input of more experienced entrepreneurs plays an important role in building confidence even in times of economic uncertainty. When an opportunity is identified, having a plan already in place allows an aggressive entrepreneur to seize the ‘first-mover advantage’ over those who are unprepared. Wannabe entrepreneurs who lack confidence because they are not thoroughly prepared are more likely to decide not to try at all. They are right to hesitate; without adequate preparation the outcome can be disastrous.

Why Do Businesses Fail?

While the Kauffman Foundation studies excel at advocating entrepreneurship, they devote less attention to the downside of starting a new business: the potential for failure (what Kauffman delicately refers to as adverse firm outcomes). It is one thing to start a business; it is something else altogether to make it into a success. The failure rate of start-ups is extremely high. Approximately 80% close in less than two years even during periods when the economy is growing. Although start-ups rates apparently remain constant, failure rates appear to increase during a recession. Some start-ups survive only a few months while others last for a year or so before finally shutting down.⁷ Whenever a business fails, the effects ripple throughout the economy. Employees lose their jobs. Suppliers lose a customer. Landlords lose a tenant. Consumers are hurt by reduced market competition. Outside investors suffer losses, and entrepreneurs and their families often go bankrupt. Worst of all, the wealth that might have been created by a successful small business is permanently lost.

Why do so many businesses fail? Economists and students of business history have been debating this question for decades but have yet to arrive at a unified theory. Two schools of thought have emerged, one emphasizing the impact of external events on individual businesses, the other focusing on the uniquely human aspects of entrepreneurial behavior.

External Shocks

According to the external shock theory, business failures are caused by economic forces beyond the control of individual entrepreneurs or the executives managing business enterprises. This is the reason given most often for the increased failure rate of businesses of all sizes over the past three years when the economy has undergone a severe contraction. The idea that business failures are caused by events external to the business itself originated with the prominent 20th century economist Joseph Schumpeter, who thought that businesses failed because of the constant increase in market competition brought about by innovation. He coined the phrase creative destruction, which has become an integral part of almost every modern day explanation of business failure or market malfunction. Schumpeter believed that the overall economy evolves and grows stronger as less innovative businesses die out and new, more innovative businesses take their place. This occurs naturally as the more innovative businesses pressure the older businesses competitively, causing many to fail. Schumpeter concluded that widespread business failure is nothing to be concerned about. Just the opposite, it is a sign of a properly functioning market, a normal, healthy dynamic within the capitalist system.⁸

Disciples of Schumpeter draw upon recent advances in our understanding of the biological sciences to support their case. According to mathematical models constructed by British economist Paul Ormerod, business failure cycles are similar to mass extinctions in the natural world and occur for similar reasons. Just as dinosaurs disappeared due to the destruction of their ecosystem by the impact of a meteor, businesses disappear due to the collapse of interdependent industry and market ecosystems caused by the impact of social, cultural, political or economic changes.⁹ Following in Schumpeter’s footsteps, Ormerod postulates an Iron Law of Failure which can be overcome only by passionate innovation and/or a business environment characterized by aggressive (macroeconomic) competition.¹⁰ Schumpeter would agree and point out that when a business ecosystem is altered (by a severe recession, for example), some businesses will survive by frantically innovating while others predictably fail as they are overwhelmed by competitive pressures brought on by the innovators. Whether competition and innovation save an enterprise or destroy it, however, Ormerod, like Schumpeter, argues that the fundamental forces that change an economy are largely beyond the control of individual entrepreneurs who start and run businesses.

Another variant of the external impact theory identifies luck as the most crucial factor in business. The argument here is that because markets and technologies are inherently unpredictable, changes¹¹ occur that can cause businesses either to expand or collapse depending upon the specific circumstances at the time. Proponents of this view call these changes luck and see random occurrences of either ‘good’ or ‘bad’ luck as decisive in the survival of a business.¹² Good luck in business is like winning the lottery. Bad luck is the economic equivalent of being hit by a runaway train. In either case, the victim has little control over what happens. Entrepreneurs look for ‘strategic opportunities’ (the result of good luck) but have to contend with ‘strategic uncertainty’ (the threat of bad luck). This cannot be forecast with any degree of accuracy and often cannot be responded to effectively even if they know what is coming.

Paradoxically, very successful businesses seem to be the ones least able to cope with bad luck. This is because they are often narrowly focused on a particular market segment or strategy and cannot adjust to sudden change. As a result, even established, well managed businesses are at risk, and in fact, many mature businesses eventually fail despite having enjoyed a great deal of success.¹³ Most economists accept these failures as normal and even healthy for the economy.

The Human Factor

Another, substantially different, approach to explaining widespread business failure minimizes the importance of external shocks or luck and instead places emphasis on what we might call the human factor in entrepreneurship. This idea has developed a large following in part because it has the eminent economist John Maynard Keynes as its spokesman.

Keynes believed that individual entrepreneurs and investors are the driving force behind the prosperity of market economies, and he attributed their activities to what he called animal spirits, those mysterious and unknowable elements of human nature that cause them to take on great financial risk in the pursuit of economic goals. Like Schumpeter, Keynes coined a clever and memorable phrase—naïve optimism—which he used to describe the psychological and emotional state of committed risk-takers.

Over time, the idea of naïve optimism has come to include scores, if not hundreds, of unique (and mostly endearing) personality traits thought to be typical of entrepreneurs and business leaders. Personality-based theories of entrepreneurship and executive management are regularly debated and updated by economists and behavioral psychologists. New ideas occasionally emerge but these experts generally follow Keynes’s lead in describing entrepreneurs in positive and sympathetic terms, seeing them as unique human beings possessing extraordinary vision, courage and leadership qualities. The exceptional personality of the Keynesian entrepreneur has been embraced by our celebrity-obsessed culture as a role model for millions of Americans who want to own their own business.

Keynes was an influential theorist who revolutionized ideas about public policy and the role of government in promoting private enterprise. But his legacy in regard to personality based theories of entrepreneurship has not been altogether positive. On the one hand, his emphasis on the role of the individual empowers entrepreneurs to believe that they can overcome market forces that are considered uncontrollable by the Schumpeter school. On the other hand, Keynes’s view of the entrepreneurial personality has been transformed into the simplistic notion that all it takes to be successful is a great deal of enthusiasm and a stubborn refusal to consider failure as an option. This unfortunate turn of events seems to have occurred because, in framing his original argument, Keynes may have chosen his words poorly. In literal terms, naïve means inexperienced, but it implies innocence and a lack of doubt about the wisdom of decisions being made. Naiveté may lead to mistakes in business, but it also elicits sympathy and is easily forgiven. Those who try and fail are treated sympathetically. Those whole fail to try for fear of failure are treated with contempt.

As for optimism, it is one the most exciting and satisfying of all emotions and has the added benefit of being infectious, so it steadily expands its circle of influence. It is considered inappropriate and even rude to criticize someone with an optimistic outlook, even when the optimism is obviously unfounded.¹⁴ A definition of entrepreneurship based on naïve optimism extols the virtues of unbridled enthusiasm and risky, speculative behavior as compared with the more subdued personal qualities of caution and calculation. The naïve optimism of individuals is a manifestation of what Alan Greenspan calls the irrational exuberance¹⁵ of larger social or economic groups, an emotion-driven set of attitudes and behavioral patterns based on what often turns out to be groundless optimism about business and investment opportunities. We have come to think of real entrepreneurs as those who toss caution aside and just do it, taking risks that someone more timid would ordinarily never consider. These personality traits are often said to be bred into the DNA of every true entrepreneur. One has to wonder if this is what Keynes really had in mind.

The Role of the Individual Entrepreneur

How important is the DNA of an individual entrepreneur in the success or failure of a business? It can be critically important. This does not mean, however, that success or failure is the result of inbred personality traits. We have all probably observed situations in which the management or ‘personality’ skills of a small business owner were not equal to the task, and the business failed. It is tempting to conclude that the entrepreneur lacked the necessary animal spirits to persist and succeed. There is a tendency to believe that a weak personality is innate and that getting depressed and giving up too quickly when the going gets rough stems from an unhappy childhood or something in the family gene pool. For a variety of reasons, the individual is not responsible if the business fails. But the opposite is also true. The idea that there are certain innate human qualities that predetermine success or failure in business can be refuted merely by looking at the incredible variety of personality ‘types’ that succeed. There are plenty of examples in which an individual’s introverted personality or management inexperience suggests a high probability of failure. Over time, however, personal growth or improved management skills enabled him to learn and adapt to the day-to-day pressures of running a business. What we expect to be a failure ultimately becomes a solid success story. Not every successful entrepreneur conforms to the Keynesian model. Most individuals can learn to be entrepreneurs and even accomplished entrepreneurs can improve their performance over time.

The role of external shocks in business failure is also usually exaggerated. It is all too easy to assume that luck is random and that, regardless of the management skills of the entrepreneur, it is impossible to turn the tide when a run of ‘bad’ luck causes a business to fail. External shock theories may make sense at the macroeconomic (national or global) level, but from a microeconomic perspective—the street level where the fate of individual enterprises is actually played out—they are contradicted both by statistical evidence and casual observation. Failure does not come crashing down on a business like a meteor from outer space as Omerod suggests. Poor quality in strategic planning and ineffective implementation of tactical decisions by individual business owners are far more important. We have two excellent examples of this in just the past decade: the attack on the World Trade Center in 2001 and the financial panic of 2008-2009 which led to the Great Recession. These are among the most powerful external shocks in the entire history of the U.S. economy.¹⁶ The evidence is not clear, however, that they were the primary cause of widespread business failure in their aftermath.

The Attack on the World Trade Center in 2001.

The attack of September 11, 2001, was a horrific and unexpected event that had a dramatic short-term effect on the national economy, both financially and psychologically. At the time, I owned a business that employed one hundred people in locations spread across four states. I saw first-hand how demoralizing and confusing a sudden event like this can be. As head of the business my immediate instinct was to project calm, if for no other reason than we were in no immediate danger and I had no idea what was going to happen. Within a few days I held meetings with our employees and announced that the company would adopted a business-as-usual attitude for at least a period of three months (to the end of the year) or until we could more accurately assess economic conditions in the wake of the attack. I then told our customers the same thing, i.e., that we were strong and optimistic about the economy surviving the shock and that we would be there for them when they needed us. The response was overwhelmingly positive. Our employees were relieved to know that they would have a full paycheck through the upcoming holidays, and their effort and cooperation in ramping up customer service was exceptional. Our customers responded accordingly.

Meanwhile, more than one competitor offering similar services at comparable prices, who seemed to be operating successfully prior to 9/11, panicked and started closing offices, cutting back on staff and reducing service levels. Their assumption apparently was that the economy would contract sharply and they opted for a strategy that would enable them to survive the anticipated downturn. Not surprisingly, many of these businesses collapsed. Some never recovered. My assumptions were different. It was impossible to tell what was going to happen, and therefore there was no reason to overreact.¹⁷ I noticed the same pattern of management decision-making among our customers: some disintegrated almost overnight while others steadied themselves in just a few days and seemed generally unaffected. Overall, the economy reacted positively to the terrorist attacks. As competitors pulled back, our business increased, and six months after the crisis started it had nearly doubled. Our experience was typical of the economy as a whole. With some help from the Federal Reserve, which lowered interest to stimulate economic activity, the 9/11 shock was followed by an economic boom that lasted more than half a decade.

Neither the extreme variations in management response nor the robust post 9/11 economy can be explained by an external shock theory. An analysis of the economy during this period suggests that, whether we look at events at the macro- or microeconomic level, the terrorist attack did not lead to economic disaster either for most individual firms or the economy as a whole. Individual management decisions played a much greater role in the final outcome for each business.

The Great Recession of 2008-2009.

The financial collapse of 2008 and the deep recession that followed provide a more recent example of an external shock which, unlike the attack of 2001, has had a long-term effect on the U.S. economy. Technically the Great Recession is over and the financial system has been stabilized, but it is estimated that it will take years for the economy as a whole to fully recover. In fact, as discussed in more detail in Chapter Eight, many economists do not think we will ever fully return to the pre-recession economy.

Has the Great Recession increased the rate of small businesses failure? Although we do not yet have detailed statistical data on business failure rates in the period since 2008, anecdotal evidence indicates that there has been a sharp increase in the number of small business failures. A more interesting and difficult question is whether these failed businesses would have survived if there had been no recession. A case study is appropriate here. Let’s look at a specific example of a small business that failed late in 2008 and try to pinpoint some of the reasons why this happened.

Case Study: The Local Farm and Garden Center

Donna and I live in a rural area that is slowly trending suburban. Like many of our neighbors, we had come to depend upon a farm and garden center in the nearby town. I stopped by every couple of weeks for a sack of feed and a few bales of hay or alfalfa for our horses. When I first started buying from the store the customers were mostly local farmers who always seemed preoccupied by the one thing most vital to their way of life: the weather. Realizing this, the farm and garden store owner had placed a video monitor on his front counter, one of those old-fashioned cathode ray tubes (CRTs) with a green image and black background. He kept it tuned to the USDA (United States Department of Agriculture) weather radar channel, which shows current weather conditions in the local area. This information is readily available both on local TV and over the Internet but the farmers were drawn to the screen whenever they came into the store. Sometimes three or four men would be standing around it trying to recall how much it had rained last year and speculating about whether the hay was going to get enough moisture to allow another cutting before the end of summer. It was great marketing by the farm and garden because nobody was asking about the price of insecticides or fertilizer. Some simply handed the store clerk a list of the items they needed and headed straight for the weather radar. Others didn’t want to buy anything; they just stopped in to visit with their friends and find out what the weather was going to do that afternoon. Checking the weather radar at the farm and garden became a regular activity for some members of the local community, a social interaction they looked forward to every day. It drew people into the store but at the same time drew their attention away from the fact that they were spending money. It was an imaginative use of readily-available information and helped the farm and garden center to differentiate itself from its competitors.

One day I noticed that the CRT was gone and some of the shelving and countertops in the retail area were being dismantled. As soon as I had finished loading my hay bales I asked the owner what was happening. He told me that the business was in the process of moving into a brand new building a few miles down the road. He was excited about the change and we talked for a while about his plans for the new location. He invited me to attend their upcoming open house. They planned to give away some door prizes and serve cold Coca-Cola. Because he was taking on entrepreneurial risk by disrupting and expanding his business, I took an immediate interest and made a point of touching base with him each time I visited the new store. He seemed to enjoy the conversations and I became privy to many of the ups and downs of the business over the next two years (2006-2008). I realized that this would be an interesting case study for my book and I started making notes after each visit. It turned out to be a fascinating story that sheds light on why some small businesses succeed while others fail.

The day of the Grand Opening came and the first thing I noticed when I entered the new store was that there was no weather radar CRT sitting on the front counter. This was by design. The owner had decided that the local market was evolving and that his business had to keep pace if it were to grow. This meant catering to an entirely different type of customer. As with many farm communities, the area serviced by the farm and garden was being suburbanized as residential subdivisions replaced row crops and cattle. In earlier decades, the owner’s father had built the business by supplying farmers with bulk fertilizer, cattle feed and other farm staples. But the farm community was in decline as farm families who had worked the land for generations were selling out to city folks looking for a lifestyle change. Even where farms survived, the slow subdividing of large tracts of land into 5-15 acre ‘hobby farms’ changed the demand for products. Fertilizer and cattle feed (brought in by train – the old location was on a rail line) gave way to growing demand for gardening products, and tractors were replaced by lawn mowers and roto-tillers as small-scale farming became more popular. The owner of the farm and garden was well aware of the shifting demographics. The farmers had to go, and one way to send that signal was to break up the social group that had coalesced around the daily weather reports. When he moved he had all the excuse he needed to get rid of the weather radar.

The plan to reposition as well as rebrand the business to take advantage of the growing number of lawns, yards and small flower, vegetable and organic gardens required a significant change in sales and marketing strategy. There would be a lot more emphasis on ‘garden’ and a lot less on ‘farm.’ A good way to do this was to change the product mix being offered. Bulk cattle feed and row crop fertilizers were no longer available. In their place the business began stocking wood chips, peat moss, bales of pine straw, crushed stone, bricks and flagstone (for flower beds and garden paths and walkways). It also started carrying shrubs, outdoor plants and flowers and a full line of herbicides, insecticides and plant fertilizers. These would appeal to homeowners with fancy landscaping and large front yards. A large retail area was devoted to a display of low-end lawn mowers and small chain saws as well as other tools used for flower gardening and trimming shade trees and shrubs. The new store had a definite retail atmosphere. It was bright and cheerful. If the farmers were selling out to developers, it seemed to make sense to cater to the new group of suburban customers.

Long before the move, as the owner started to think about a shift to retail, it had become apparent to him that the old building was no longer suitable. It was dirty, poorly lighted and had only a few parking spaces. Upscale shoppers wanted an upscale shopping environment. Moreover, the retail customers did not live in the center of town or along the rail lines where the old business was located - they lived in the suburbs. Farmers drove mud-spattered pickups and would park anywhere but suburbanites drove BMWs and SUVs. Easy access from the Interstate and convenient parking were important. The old building was in the wrong location. The business needed to be moved. Instead of renting new space, however, the owner made a major strategic decision to purchase several acres of land on the outskirts of town and build a new building complete with warehouse and outdoor gardening center. The location was closer to the residential growth that was occurring in the area and was better positioned to take advantage of suburban traffic flow. The new building was designed to have a larger, more modern retail area and plenty of space outside to display shrubs and plants. It even had air conditioning in the warehouse, an expensive luxury in the hot southern climate. Both the building and the grounds were bigger and brighter, and there was ample parking and several extra acres for future expansion. The owner put $200,000 cash into the project and (with the help of family) did some of the work on the new building himself at night and on weekends to lower construction costs. The balance of the project was financed by a local bank.

The new location and facilities seemed like a smart move marketing-wise but it involved a huge amount of new debt for a business of that size. The owner had purchased eight acres of land, far more than was necessary for his business. He carved out a four-acre parcel for himself and listed the rest of the acreage for sale through a commercial real estate broker. He expected to ‘flip’ the property in 12-24 months. In retrospect it is clear that moving the business to a new location was as much an investment in real estate as it was an investment in the existing business. Commercial land prices were rising and there was money to be made in land speculation. If the farm and garden business continued to grow as projected, the mortgage payment on the land and building was manageable.

There were also other challenges. Switching the customer base is a risky maneuver requiring flawless execution. Once the farm and garden began selling live plants, for example, it was suddenly in competition with large, well-stocked retail nurseries in the area. These were formidable competitors, chains that had both large wholesale and multi-branch retail operations. They could respond quickly to changes in the weather, the seasons and the tastes of fickle consumers. The farm and garden was at a disadvantage in this business and actually had to buy plants from the wholesale division of one of its retail competitors. The lawn mower and hand tool business put it into competition with a nearby Home Depot as well as a local Ace Hardware. These, too, were major competitors with greater buying power, huge inventories and much more retail space.

Meanwhile, the remaining farmers with their pickup trucks and overalls were rubbing elbows with urbanized soccer moms driving SUVs filled with pre-schoolers. The farm and garden retail space was attempting to combine gardening tools and gourmet bird seed with bags of goat feed and rolls of barbwire fencing. It was an unusual mix and the retail ambiance was peculiar. I don’t think either group felt at home. For example, the farm and garden always kept a couple of barn cats around. The cats were friendly, and all of the regular farm customers knew them by name. The cats were so popular that the owner made a point of relocating them from the old building when the business moved. They lived in a box in the owner’s private office. But, as any farmer knows, cats have a job to do where animal feed is stored, catching the rats and mice that infest the warehouse. I was at the store one time when one of the cats ran through the retail area with a kicking, squeaking mouse clamped firmly in his jaw. He was headed for the owner’s office to show off his catch before dismembering it and having a meal. A farmer in the store didn’t even notice what was happening, but a lady carrying a tray of pansies out to her car was horrified. I doubt she ever came back.

Other things started to go wrong. Just as the move was completed and the new facilities started to function as planned, a severe drought began in Georgia. Businesses of all kinds that were dependent upon steady rainfall and long growing seasons suddenly experienced a falloff in sales. The first year was bad, but by the second year, rain was so scarce that municipalities put watering restrictions into effect in most residential areas. Customers who could not nurture their plants with regular watering became reluctant to invest in them only to watch them die. Interest in gardening and shrubbery declined. Lawns turned brown as well and the sale of mowers and related accessories and chemicals deteriorated. Out in the countryside, wells began to run dry, and farmers cut back their herds of beef cattle. The enthusiasm for outdoor recreation declined as summertime temperatures reached 106°. One of the major gardening chains in Atlanta declared bankruptcy and was taken over by an out-of-state competitor. Most of its local stores were closed. The new marketing initiative of the farm and garden depended on good growing weather. But as any farmer or gardener knows, the climate constantly changes.

As sales began to decline, the farm and garden owner attempted to borrow against a line of credit he had arranged with his bank. The original amount committed to by the bank was $200,000, which just happened to be the amount of cash he had originally invested in the project. Any new loan, like the existing loan, would be collateralized by the company’s assets, including equity in the real estate. But when he spoke with his banker, he was informed that from that point on the bank would expect a minimum payment of $2,000 per month just to keep the line open even though he had not yet borrowed against it. This monthly fee would be required even if he never borrowed against it. If he borrowed, the minimum payment would be $2,000 per month no matter how small the loan. Note that these draconian terms from the bank were presented to the owner in 2007, a year before the financial panic of 2008 had become a factor in the economic slowdown. The bank may have recognized that the farm and garden business was in trouble and decided to play it safe by reneging on the commitment for a line of credit by placing impossible terms on the payback requirements. Or perhaps the bank itself was under stress. Whatever the reasoning, the bank pulled the rug out from underneath the business just at a time when an infusion of working capital was desperately needed.

With no cash available, the business owner’s next best option was to try to accelerate the sale of his extra property by lowering the price. He had ample road frontage and acreage for another retail store, and given enough time, a sale might have been possible. But commercial real estate is illiquid and the resale market moves slowly. Unlike residential real estate, it can take years to sell even a good piece of commercial property. He didn’t have years: if it didn’t start raining, he had a few months at most.

Meanwhile, new competition had moved into the area. Tractor Supply Company (TSC), which describes itself as the largest retail farm and ranch chain in the United States, opened a store about two miles away. It was close to a major exit off the Interstate