Use Caution Extending Credit to Startup Companies
Calculating the Risk of Selling to Start-ups and Small Businesses
Startup companies are intriguing, but can also be an enigma. The successful ones receive a lot of publicity and are celebrated widely. Who will be the next Apple, Google, Facebook, or Nvidia? If you happen to be a supplyier to a successful startup you’re in luck. As they grow, so will their purchases from your firm. A small, new account can become one of your top customers in a few years, and a key contributor to the growth you seek.
The problem with startup companies: there is a high probability they will fail, leaving you with a bad debt on your books. Here’s the failure rates derived from the US Bureau of Labor Statistics:
20% of startups fail by the end of year one
Another 10% are likely to fail during their second year of operations, meaning 30% don’t make it to year three
Only 50% of all businesses survive to reach their fifth anniversary meaning another 20% fail between years 2 and 5
The problem isn’t just confined to start-ups. Small businesses in general have a short life span. Barely 30% make it to year ten and after 20 years, only 20% are still operating. That means 20% of those smaller firms still in business at year 5 will fail before year 10, and of those that make it that far, 10% more will fail before reaching their 20 year anniversary. The challenge with businesses that employ less than five people is even more acute. Their failure rates are roughly double that of firms with five to ten employees. Think about it. It makes sense that the small businesses that are able to grow are also more likely to survive.
The risk of failure diminishes as businesses mature and grow, but the problem for any business selling other firms on open terms is the high number of organizations that are relatively young. According to the US Census Bureau, for the 12 months ending May 2024, there were 5,441,745 new business formations accounting for nearly one out of five US enterprises. It also means we should expect well over one million of these businesses to fail in the next 12 months.
Moreover, an analysis of the aforementioned data sources reveals that over 50% of all US businesses have been operating for less than 5 years. This is because, business formations have been at elevated levels since shortly after Covid hit. Clearly, selling to young businesses cannot be avoided. That’s why it is standard to ask on a credit applications the year in which the business was formed. Years in business is a critical factor in the assessment of credit risk along with number of employees, which can be a good proxy for sales volume, something private businesses are not always willing to disclose.
Why Businesses Fail
There are a variety of reasons that businesses fail as the following chart illustrates. Cash shortages, however, are almost always a secondary effect. Whether the challenge is a lack of sales, poor management, or competitive pressures, the consequence is an inability to pay the bills.
Interestingly, failure rates apply across all industry types. It’s a myth that restaurants fail more frequently than other business types. In fact, there is little difference between restaurants, retailers, construction firms or even manufacturers. The common factors are years in business and numbers of employees.
Some startups are well funded and willing to pay in advance or upon delivery as a new customer. After they’ve demonstrated their ability to pay, they will want credit terms just like everybody else, so eventually you are going to make a decision on granting them open terms.
Most startups, however, will want and need credit starting with the first order, and many of them will be bootstrapping or otherwise be under-capitalized. Selling them on credit entails a risk of being paid well beyond terms by some startups and never by others. How much credit (if any) should you extend to a young business?
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