The Lure of False Profits: Why So Many New Businesses Fail

There seems to be a consensus that it is desirable to encourage small business start-ups and that banks are excessively cautious in their lending policy. But according to Professors David de Meza and Clive Southey, the fact that a consistent 30-40% of new businesses fail within three years indicates that many budding entrepreneurs are unsound judges of their own prospects. In an article in the Economic Journal, they argue that unrealistic optimism draws people to business in the same way that lemmings are drawn to the sea. Banks should be applauded for stemming the rush.

De Meza and Southey note that the depressing figure for new business failure is strikingly similar both over time and across different countries: the UK, the United States, Canada and even nineteenth century Edinburgh all show the same rate of entrepreneurial misjudgement. And in each case, external factors such as the state of the economy are only a minor influence on new businesses'' chances of survival.

De Meza and Southey point out that the problem is hardly new. Adam Smith reflected on most people''s ''absurd presumption in their own good fortune'' and modern psychology (not to mention the National Lottery) largely confirms Smith''s intuition. Research has shown that in many areas of life, unrealistic optimism is the norm. This bias is particularly prevalent when events are viewed as being under an individual''s own control, as is surely true of entrepreneurs. Since most of those seeking to go into business have little hard evidence on which to base their beliefs, the situation is ripe for overconfidence and it will be those with the most bullish expectations who actually enter.

De Meza and Southey''s perspective on unrealistic entrepreneurial optimism helps to explain the surprisingly low interest rates charged on business loans. The average margin over base rates is 3% and lending rates are hardly ever more than 6% over base. Borrowers may complain, but these low risk premia imply that banks don't anticipate serious default problems. Banks protect themselves by only funding intrinsically safe projects or insisting on high collateral, typically the family home. In many ways, banks act like pawnbrokers, just on a grander scale.

So why do banks refuse loans rather than compensating for the risk to themselves by charging higher interest rates, comparable to those on credit cards? De Meza and Southey suggest that excessive optimism means that the average project is a loss maker. Unlike the typical borrower, banks know this from long experience. Even if high interest rates enabled a bank to claim all project returns, it would still be down much of the time.

So the typical pattern is that only safe ventures or those with the bank''s expected return boosted by high collateral can proceed. As a result, many potential entrepreneurs feel that they are unreasonably denied finance.

Of course, wealthy entrepreneurs are able to pursue their new business schemes without the external vetting of a bank. But consistent with the idea of widespread excess optimism, it appears that self-financed firms have the worst survival prospects of all.

''The Borrower''s Curse: Optimism, Finance and Entrepreneurship'' by David de
Meza and Clive Southey is published in the March 1996 issue of the Economic Journal. De Meza
is Professor of Economics at LSE; Southey is Professor of Economics at Guelph
University, Ontario, Canada.