Understanding failure

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Shikhar Ghosh, a Senior Lecturer at Harvard Business School, has some sobering statistics about the rates of business failure. In a 2010 working paper, he calculated that the percentage of companies that fail utterly — with all assets liquidated and investors losing all their money — is somewhere between 30% and 40%. If failure is defined more broadly as being unable to meet a projected return on investment, then the rate increases to between 70% and 80%1.

The psychology of failure 4 of 7 Introduction 2 of 7

Residents of the United States, please read this important information before proceeding

This does not only apply to start-ups or early-stage ventures. Over time, even companies with a dominating market position can lose it. One study, by the Economic Historian Leslie Hannah, identified the 100 largest companies in the world in 1912, and traced their fortunes over the ensuing decades2. Between 1912 and 1995, 29% of those companies went bankrupt, 48% disappeared and just 19% remained in the top 100.
Another study by the Consultant and Author Arie de Geus found that one-third of the companies on the Fortune 500 in 1970 had disappeared by 1983, either through M&A, bankruptcy or break-up3.

Failure can be both personally and professionally devastating for those who are directly affected. But this constant process of entry and exit by new and old companies lies at the heart of economic growth, progress and improved standards of living. The Economist Joseph Schumpeter coined the term “creative destruction” to describe this process whereby old ideas, technologies and business models become obsolete as new, stronger entrants grab market share.

At a time of economic stress, the process of “creative destruction” becomes amplified as companies that are too inefficient, bureaucratic or lacking in innovative ideas find it impossible to compete. Capitalism relies on companies being allowed to succeed and fail. Periods of economic turbulence should not just be perceived negatively as a time when jobs are lost, factories mothballed and companies shut down forever. They are also an opportunity to reallocate resources, capital and talent away from failing companies to ones with greater potential.

For the process of “creative destruction” to be effective, societies need entrepreneurs who are willing to take risks and an environment that is conducive to their efforts. This necessitates not only a strong financial system that is able to provide both equity and debt capital, but also a culture and policy framework that tolerates risk and supports entrepreneurship.

To become successful, entrepreneurs need an environment where it is quick and easy to set up a company, where individuals are willing to invest in enterprise schemes and investment vehicles to provide risk capital, and where there is regulation that supports business growth. For example, in the U.K., investors receive income tax relief for investment in venture capital trusts to encourage investment in support of new business ventures.

Culture matters, too. A society that is tolerant of entrepreneurs experimenting and making mistakes will be more innovative than one where individuals fear the consequences of failure. “We need more risk-taking in the economy because what will determine economic success in the 21st century is innovation,” says Paul Ormerod, an Economist and Author of Why Most Things Fail: And How to Avoid It. “As such,” Mr. Ormerod continues, “the only way we can create that environment is to embrace failure.”

Emerging entrepreneurs

Among the 2,123 high net worth individuals surveyed for this report, 74% overall agree that viewing failure positively is essential for an economy to grow. But the extent to which different cultures and regions tolerate
and embrace failure varies depending on the dynamism of the economy and its pace of economic growth.

Among respondents from Europe and the U.S., a sizable majority of 70% believes that viewing failure positively is essential for an economy to grow (see chart 1). The U.S., in particular, has always been regarded as having a culture that is tolerant and embracing of failure. It is often said that Silicon Valley entrepreneurs see failure as a “badge of honour” and will happily talk about their past mistakes to prospective investors. Bankruptcy laws can also create a more conducive environment for
entrepreneurship. In the U.S., companies in financial distress have a range of options available, including out-of-court settlement, reorganisation of the debtor’s business affairs through the Chapter 11 process, or liquidation. By giving entrepreneurs the option to reorganise their business through Chapter 11 rather than face automatic liquidation, the U.S. policy environment provides entrepreneurs with a second chance that is often not available in other countries4.

Overall, tolerance of failure is reasonably high in the U.S. and Europe, but it is considerably greater in faster-growing regions of the world. For example, an average of 83% of respondents from the Middle East and Asia believe that viewing failures positively is essential for an economy to grow. Respondents in the Middle East and Asia are also strong believers that past entrepreneurial failures will increase the chance of success in their next venture (see chart 1).

A high tolerance of failure is essential in economies that require entrepreneurs to overcome significant obstacles in order to succeed. Entrepreneurs in China and India, for example, have had to learn how to deal with numerous constraints, including a lack of resources and a bureaucratic environment that can often stifle enterprise. India ranks 132nd out of 183 countries on the World Bank’s Ease of Doing Business
ranking5 and 166th on its ranking for starting a business. On average, it takes 29 days to launch a business in India. In the U.S., which ranks 4th on the rankings for starting a business, it takes just six days,
while in the U.K. it takes 13 days6.

Chart 1

Regional variation in attitudes to entrepreneurship and failure
Percentage of respondents who report “Entrepreneur/Business Owner” best describes their current occupation.

Cultural attitudes that support entrepreneurship
Percentage of all respondents who agree with the following statements:

Viewing failure positively is essential for an economy to grow.

Past failure in entrepreneurial endeavours increases the chance that a new business will succeed.

If you work hard enough, anyone can learn how to become a successful entrepreneur.

Cultural attitudes that support entrepreneurship continued...
Percentage of all respondents who agree with the following statements:

I respect people who persist in the face of failure.

The recent global crisis has provided me with opportunities.

An entrepreneur’s business is failing, instead of cutting losses the entrepreneur should persist.

No wonder, then, that respondents from Asia strongly value persistence in the face of setbacks. For example, an average of 63% of entrepreneurs from the Middle East and Asia agree that anyone who works hard enough can become a successful entrepreneur. The corresponding figures from Europe and the U.S. are lower (see chart 1).

Navi Radjou, an Independent Strategy Consultant and Co-Author of Jugaad Innovation, argues that this persistence and ability to work around constraints and daily uncertainties has exerted a huge influence on how entrepreneurs in emerging markets approach innovation and the development of new ventures. Many are accustomed to using improvised solutions, seeking opportunities in adversity, doing more with less and thinking flexibly. The word jugaad, a colloquial Hindi word that roughly translates as ‘‘an innovative fix or improvised solution,’’ captures this approach.

“Entrepreneurs in emerging markets operate in a highly constrained environment, in which they must engage in a constant process of trial and error in order to overcome everyday obstacles and devise creative workarounds to solve problems,” says Mr. Radjou. “This requires resilience, a reluctance to give up and a perception that failure is not an absolute outcome but one step on the journey to success.”

These dramatic differences between developed and emerging markets translate into different frameworks for entrepreneurial investment. In the mature, developed markets, there are established processes and institutional networks of corporate finance houses, brokers and angel investors to facilitate connections with entrepreneurs requiring funding. The role of certified market makers is more formal, and entities exist to take on roles for sourcing deals and capital. There are also more options for investors, ranging from direct investment in individual private companies, single manager funds or diversified fund of funds.

Entrepreneurs in emerging markets operate in a highly constrained environment, in which they must engage in a constant process of trial and error in order to overcome everyday obstacles and devise creative workarounds to solve problems.

In emerging markets, it is more challenging to gain access to reputable players because the business culture is developing and roles within the process are less clear. Without the reliance on institutions as a proxy for trust, informal social networks and the reputation of the individual carry more weight. An investment in contacts, due-diligence and in-depth research has a higher pay-off than in the developed markets.

Longstanding experience of dealing with a challenging operating and business environment gives these entrepreneurs a powerful foundation on which to build future growth. As these economies continue to grow and benefit from rising domestic consumption and per capita incomes, their advantages will become greater still. The U.S. and Europe may have dominated entrepreneurship in the second half of the 20th century, but the landscape is shifting and entrepreneurs from Asia are catching up quickly. A tolerance for failure, and the ability to learn from setbacks, will be an important determinant of creating this vibrant entrepreneurial culture.

1 http://hbswk.hbs.edu/item/6591.html

2 http://www.nber.org/chapters/c10235.pdf

3 The Living Company: Habits for Survival in a Turbulent Business Environment by Arie de Geus

4 Neither Barclays in the U.S. nor its Wealth and Investment Management employees in the U.S. render tax or legal advice.

Please consult with your accountant, tax advisor and/or attorney for advice concerning your particular circumstances

5 The World Bank’s Ease of Doing Business Index ranks countries according to the conduciveness of their regulatory environment

to the starting and operation of a local firm

6 http://www.doingbusiness.org/reports/global-reports/doing-business-2012