That ‘7/10 businesses go broke’ statistic …

Everybody quotes it, but can it be true?

Regarding the cynicism expressed about India by Peter Ziehan (see previous post), I was pondering the real-life probabilities of India actually making economic progress beyond the mean of its previous performance. The so-called ‘Hindu rate of growth’ of barely above 1% – often the historical norm under the socialist state planning of the classic Congress/Gandhi-dynasty years –hopefully has disappeared forever. A better rate was jump-started back in the 1990s by the PV Narasimha Rao administration, and then continued by the BJP until they were ousted in 2004. By 2013 Congress had managed to put the brakes back on, but India is now pootling along at +7% growth per annum according to GDP. Granted, GDP’s a terrible measurement as it only counts economic activity, not profitability or productivity. But India’s is the best rate in a bad neighbourhood – the neighbourhood being this planet right now.

The question in my mind was how difficult could it be, how likely is it, for India to make a success of things. Is it more or less probable over the next five years? I was watching a lecture by Nobel prize-winning psychologist Daniel Kahneman in which he was talking about bias. Now I adore Kahneman, but he quoted a statistic I have often heard bandied about: namely, that after five years, 7/10 new businesses have gone bust. Kahneman used this figure to stress the fact that entrepreneurs must be insanely optimistic – positively biased, in other words – to ignore the fact that they are much more likely to fail than succeed in any new venture. This point, in turn, was raised in support of Kahneman’s thesis that most people take risks only because they are unaware of them, or at least of the relative odds of their success and failure.

I am not a psychologist, and I am certainly not a statistician. But I can do simple sums and it appears to me that the 7/10-go-bust statistic is bogus; or at least in its bald form it does not mean what it is employed to mean. I think that Kahneman quoting it in the context of over-optimism/underestimation of risk is an example of what he himself originally explained to the world as hindsight bias – making false sense of random things post facto.

Say you were a new businessman and were confronted with the 7/10 casualty number. Would you run away? I don’t think so, even if at first sight the odds are about as appealing as a ten-minute session of Russian roulette. The reason is that the 30% survival rate is after five years, not every single year. Only 30/100 of the original cohort are still there after five years, but what is the rate of attrition in each individual 12-month period? Only between 10-15% on average. If I was starting a business and discovered that my chances of survival in the first year were roughly 90% I would probably be happy to take the risk: those are pretty good odds. Remember these possible real life conditions as well:

  • Not every business is properly thought through, so there might be a higher-than-average number of (predictable) failures of flaky ideas in the first couple of years.
  • Some entrepreneurs might feel that the new venture does not suit them and decide to withdraw without necessarily incurring an overall loss.
  • Other entrepreneurs might decide to close their business and open a different one instead due to conditions encountered; again, a loss in the original (counted) business might be offset by profits elsewhere within the five years (not counted).
  • Certain businesses might close due to death or illness or other reasons that have nothing to do with the profitability or viability of their venture.
  • Some businesses may be so successful within five years that they are taken over by other businesses and vanish from the cohort.

I am not saying that none goes bust, but the plain vanilla ‘7/10 fail’ figure tells us absolutely nothing about the actual conditions. Remember, even knowing nothing else about the businesses, the average risk is under 15% in any given year. Factor in other possible causes for a business to leave the cohort and it might not be as bad as it looks.

Even if you say that the ‘7/10 fail’ figure is based on recorded bankruptcies, I would have to counter it by arguing that not every failed business files for bankruptcy (so failure rate possibly even higher – and more unlikely); and that many businesses file for bankruptcy just to stiff their creditors and re-open days later under a new name (a notorious tactic in the restaurant trade). The point is the 7/10 figure means little on its own, and I believe overstates the probability of failure.

Other factors can also affect the likelihood of success, and neither are these taken account by the statistic Kahneman quotes:

  • The biggest single determinant of success in business is the proportion of debt to capital. The more debt a business takes on, the more fragile and liable to downsides it is. There is a massive difference between beginning a new venture with a large bank loan compared to fully self-funding it or starting up with equity from partners. Debt is a big predictor of survival.
  • It matters at what point in the business cycle the venture is begun. This is related to debt, because at a late stage of the business cycle credit tightens as all the loans taken out at the beginning of the previous economic recovery (5-7 years before) have to be paid back. Debt is more expensive at this point, and demand typically contracts as spending is impacted by debt repayments/lay-offs and so on.
  • On average more than 5/10 businesses must survive (or fewer of them must be far more than averagely profitable), or productivity growth in an economy would not persist over time – as it has done for centuries now. Ray Dalio explains both the credit, or business cycle, and overall productivity growth here.

I suppose my point is that optimism is broadly justified in relation to future economic prosperity, or at least that it is not as dire as the ‘7/10 fail’ statistic looks at first sight. In India’s case, many of the things that contributed to economic sluggishness and failure in earlier times came from the government. Left to themselves I think people are perfectly capable of making a success of what they do. They might not end up as multi-millionaires, but without bureaucratic interference they are usually well able to feed and clothe themselves and enjoy life.

For decades India suffered from top-down interference and corruption, over-regulation and all manner of official nonsense in every aspect of life. If nothing else, Modi is ensuring that the government, instead of interrupting everybody as people go around trying to make a living, is now trying to help – holding people’s coats for them as they set out to make money, rather than picking their pockets.

We shall see. Sometimes the injunction to medical doctors – First, do no harm! – is a good one to apply to governments, too: Keep your damn nose out and one day 7/10 failures will be a mere statistic.

Leave a Reply

Your email address will not be published. Required fields are marked *