© 1997 Deva Industries, Inc., All Rights Reserved

The House says the odds are in your favor, but are you just shooting craps with your PEO?

While the small business arena is a favorite marketplace, bigger PEOs have successfully pursued larger small businesses and even some businesses with over 1,000 employees. However, an industry sample showed an average worksite employees per client of 14⁴. Small businesses will continue to be a major market for the industry because they need the products and services provided at PEO economies of scale, and PEOs are enjoying reasonable profits.

Nevertheless, when viewing the marketplace, a balanced perspective is necessary. Therefore, the purpose of this article is to conduct a cursory analysis of the dynamics of the small business market to include both growth and dissolution. While the potential may be impressive, both positive and negative attributes should be known, understood and planned for. PEOs are encouraged to consult the sources and execute their own analysis to meet individual needs.

By segmenting the marketplace, some insight is gained into the contribution of women and minority entrepreneurs to small-business growth. Women and minority owned small businesses continue to be major contributors to the economy.

The latest data for these entrepreneurs does not include all minorities, only Women, Blacks and Hispanics. As shown in Table 1, in 1992 close to 6 million women owned firms; there were nearly 621,000 Black owned and 772,000 Hispanic. Women owned businesses accounted for close to $643 billion in sales for 1992, while Hispanics accounted for about $73 billion and Blacks $32 billion. Furthermore, Women owned businesses provided jobs for 15.5 million persons⁵.

Looking back to the 1982-87 period when data for all minorities were available, Table 2 shows Asian American / Pacific Islander were the major growth small businesses, up slightly over 89 percent from 1982, followed closely by Hispanics. Hispanic business growth for both periods is exceptional. Moreover, all of these business owner types are rapidly becoming major players in the smaller business marketplace.

Percentage change in job growth by size and industry are shown in Table 3. The 1-99 size companies are the drivers, whereas the 100 + have been lagging. More specifically, in the 1990's the fastest job growth sector for small businesses has been restaurants, outpatient care facilities, office of physicians, special trade construction contractors, computer and data processing services, credit reporting and collection firms, medical and dental laboratories, providers of day-care, and counseling and rehabilitation services⁶.

Looking at the regions, since 1985 the South Atlantic region had the strongest and continuing small business growth with the Pacific region second. There has been reasonable growth in the East North Central Region with the Middle Atlantic and New England regions having slight growth. The other regions have been declining, with the West South Central region showing major business start-up decline.

Addressing 1996 growth, 170,475 companies started, employing 846,973 people. Figure 4 shows start-up by region and state. Relative to region, the South Atlantic had the largest number of starting companies with 32,142, followed by the Mid-Atlantic 30,137, Pacific 30,070 and East North Central 23,280. From a State point of view, the largest number of start-ups were located in California with 23,987 followed by New York 15,174, Texas 12,329, and Florida 12,299.

In total, from a positive perspective, most of the above data demonstrates a robust small-business economic climate, supporting the enthusiasm throughout the PEO industry. Women and minority firms are growing contributors, with Hispanic and Asian start-ups the fastest growing. The 1-99 employee size companies have accounted for the majority of the growth and this percentage is expected to increase through the end of the century. Much of the growth is expected in the health related fields. The major growth regions are projected to continue to be the South Atlantic and Pacific, with California being the leading small business start-up state.

As can be seen, small businesses have been, are, and will continue to be the backbone of the economy. However, a large percentage of start-ups will end in dissolution, i.e. businesses which will fail or discontinue operations. Only 30 percent will survive!

Looking at dissolution relative to small business size, Table 4 shows the attrition rate by those creating less or more than 5 jobs. In all cases smaller firms have the higher percentage dissolution; by year 8 almost 47 percent will disappear. Nevertheless, the 5 plus employee firm dissolutions are not to be ignored for they track fairly close to the 1-4 firms for the first 6 years. Moreover, a large number of 50 to 499 employees firms will dissolve in this continuing 8 year start-up and dissolution cycle.

The franchiser dissolutions have a dual meaning for the PEO industry, particularly those who franchise PEOs or establish relationships with franchisers to leverage for growth. The fact is, franchisers on the average have a higher dissolution rate than any other business type. Table 5 compares dissolutions; only the 6 year dissolution time frame for all companies shows small differential in favor of the franchisers. Therefore this type of business could be assumed to be a higher risk. Recent research speculates that up front royalty, marketing and other fees may make the costs exceed the benefits; moreover, as a group, owners tend not to be as highly educated as other small business startups.⁷

What business will fail, When and Why? These are important questions to be answered when marketing and/or sales personnel are qualifying prospects. So who are risk industries? Dun & Bradstreet has collected and analyzed such data for 9 industry categories. Dun defines failures as "businesses involved in court proceedings or voluntary action involving losses to creditors". Businesses that discontinue operation for reasons such as loss of capital, inadequate profit, ill health, retirement, etc. are not recorded as failures.

As depicted in Table 6, the highest consistent failure rate of 20 percent or more in the first 3 years are associated with services, retail, wholesale, transportation and public utilities, manufacturing and mining businesses. Moreover services, retail, wholesale, transportation and public utilities and manufacturing have average failure rates exceeding 40 percent by the end of their 5^th year. These 5^th year failure numbers are fairly consistent since 1990. For the 6 to 10 year time frame failures for all industries, with the exception of finance, insurance, real estate and construction, cluster in the 20 percent range, with mining, transportation, and services averaging in the high 20s.

Within the 9 industry categories, there appears to be business types which consistently have, by far, the highest number of failures of any others in the category. For example, the Dun & Bradstreet data for 1991 through 1996 shows within Agriculture, Forestry and Fishing, both Agricultural Crop Production and Agricultural Service businesses having 2 to 3 times the failure rate of the next business type, and 30 times or more of others in the category. This is true for all the business types listed in Table 7. Only those classified as a miscellaneous business in each category usually have higher failure rates.

As can be seen, when compared with previously presented data, the fastest growing business types are also among those with the highest failure rates. These include special trade contractors, eating and drinking establishments, machinery and equipment suppliers, computer and data processing services, along with health and social services.

What are the reasons businesses have failed? Table 8 shows 7 cause classifications: Neglect, Disaster, Fraud, Economic Factors, Experience, Finance and Strategy. Percentage by industry is presented for 1993, the last year data is available. By far the greatest number of failures were associated with interrelated Economic and Financial causes, accounting on the average for 82 percent. Moreover, both accounted for 93 percent of service industry failures. Within Economic causes the preponderance of failures were attributed to inadequate sales and industry weakness. Financial causes were primarily associated with burdensome institutional debt, heavy operating expenses or insufficient capital. These Economic and Financial reasons and percentages are fairly consistent beginning in 1989. However prior to 1988 -1989, the experience factors also make a large contribution to failure, including such reasons as a lack of business knowledge, lack of managerial line experience or incompetence, which bore the greatest burden for business demise. Dun has consolidated some Causes categories and attributes since 1988-89. See prior reports for more detail.

Where are the failures occurring? Historically speaking⁸, during the 1988-91 period, all regions were having major failures with New England, Middle Atlantic, Pacific and South Atlantic leading the way. Since then failures have been steadily on the decline in the New England and South Atlantic regions. In the past two years, increased failures have been recorded in the West South Central averaging 5.5 percent, and Mountain with 11.2 percent. Moreover, for the 1995-1996 period, East North Central and East South Central and Pacific regions have shown a 9.5, 10.7 and 5.5 percent failure increases respectively.

From a current perspective, 1996 data in Figure 6 distributes failures by region and states; 71,811 companies failed, up slightly over 1995. The Pacific region has by far the largest number, followed by the Mid Atlantic with less than half that of the Pacific; West South Central, South Atlantic and East North Central each are in the 8,000 failure ranges. By state, California and Texas have the largest number of failures; New York, Pennsylvania, Florida, Oregon, Illinois, New Jersey, Ohio and Colorado are in the 2,000s.

Comparing business failure regions in Figure 6 with startups portrayed in Figure 4, it can be seen, for example, the Pacific region had 30,070 startups and 20,970 failures; contrasted with South Atlantic with 32,142 startup and only 8,529 failures; or a failure/startup ratio of 1.43 versus 3.76 respectively. In other words, the South Atlantic region has close to 4 times the business startups as it does failures, or a large net gain in businesses for 1996. With the exception of the West South Central, which was second to the Pacific in failures, all others can be seen to have fairly good business gains during 1996.

After looking at the discontinuance and failure data, What seems to tip the scale to success, besides good luck and persistence? Success and failure are not necessarily straight lines to the top or bottom. So what are some possible indicators underlying the data?

General Small Business Indicators ^{9, 10, 11, 12}

Government funded research points to several possible success/failure indicators for small businesses. However, these findings should not be considered the final word on the topic, but considered as guidelines. Generally speaking, the following are indicators of businesses more likely to succeed. These are not necessarily in order of importance.

- Greater number of employees

- Sales dollar volume

- Years in business

- Open market competition

- Availability of large amounts of capital

- Founder run company

- Long tenure management

- Better educated management

- Efficiently run operation

- High quality business

- Second generation management brought up in company

- Purchased older business, and

- Long term management remains when purchased

Interestingly, it was found when employee size reached the 5-9 range discontinuance dropped from 66.1 percent to 14.9 percent; at 10-19 it fell to 5.5 percent; at 20-49 it fell to 2.4 percent, and at 50 plus, 0.9 percent. Similarly, as total sales revenues rise, discontinuances drop. At $100,000-$199,999 discontinuance was 6.1 percent, down from an average of 17.5 percent for all those companies under $100,000; at $500,000-$999,999 it was 1.2 percent, and over $1 million 0.7 percent.

It is also obvious from the listing a key factor in survival is management experience, tenure and education. These all tend to relate to high quality and efficient operations. However, management founders with 23 plus years in business tend to have increased discontinuance. Another dimension of management is that founder run small businesses have a greater survival rate than non-founder. Furthermore, older small businesses which were purchased tended to be sounder, more survivable than younger purchased businesses. In fact, an early sale of a young business is indicative of a possibly poorer quality business.

While education is an important ingredient in the management picture, experience is more important. One could say for example, fifteen years diversified management experience would outweigh an MBA from Harvard with little or no experience. Another point, the research indicated those businesses catering exclusively to a minority rather than a diverse market are more likely to dissolve. Finally, for white male owners, all other factors controlled, the firm age is the strongest single determinant of small business survival.

The pursuit of larger, fast growth companies by the PEO industry can be particularly high risk, given the larger number of dollars involved and day to day unknowns associated with rapid growth. Each year, Forbes Magazine¹³ selects its top 200 hot growth, public small businesses evaluating such factors as return on equity, 5 year growth, value of $10 thousand invested, and management. Over the years, only 42 percent have graduated to bigger and better things, 58 percent have encountered difficulty, some ending in bankruptcy, reorganization or liquidation. Generally, Forbes has found the downfall of these fast growth small companies to be:

Support infrastructures relates to personnel, financing and products/services inventories, which cuts a large swath across a company's capabilities. "Numbers aren't everything" is pointed out. Some of the key insight factors never pass through the profit and loss statement --- such as customers thoughts about the company, management's main motivation, employee morale, and great new products in the pipeline or reaching the market. Moreover, a key point that was made about management is their need to have the capability to cope with internal and external multifaceted complexities of a rapid growth environment; many do not!

So the key question is ... What does all of this mean to me?

All things being equal, there is a high probability if a PEO were to randomly select its clients, dissolutions and failures would approximate the rates discussed. Those PEOs concentrating in high failure geographic areas or on the consistent high failure business types would more than likely have even higher risk and client failure rates. You may say, "We have client selection criteria for minimizing risk". However, are these criteria rigorous enough? When were they last updated?

Further, is there client risk maintenance criteria? In other words ... Is there ongoing criteria to identify potential failure risk? Why? While general client turnover can have a financial impact, unforeseen failures can cripple or create the foundation for a PEOs demise. In addition, for public PEOs or those thinking IPO, shareholders are expecting growing profits and pursuing high risk clients without safety nets could lead to unhappy investors and poor stock performance. Knowing the symptoms before and after relationships are established, and putting protective systems into place is the key to survival in this high risk market. Given the percentage of failures, qualifying clients should be an ongoing endeavor. The above discussion of specific indicators provides some insight into what to look for initially and as you continually qualify clients.

It is obvious from this brief analysis that high risk industries and specific business types can be identified from data available from the Federal Government and Dun & Bradstreet. Using these, Workers' Comp and other data, a PEO can classify its clients and determine where they stand relative to overall risk. Furthermore, former clients also can be analyzed to determine risk trends. In other words, a PEO can create more precise Risk Profiles and establish not only acceptable risk levels, but also determine whether risk is remaining the same, increasing or decreasing.

By establishing and using Risk Profiles, PEOs may be able to control risk intake. Acceptance criteria that has worked in the past may not be as useful today! As the industry has matured and learned more about itself and working relationships with clients, new criteria may be needed and/or current criteria updated. This is particularly important considering the expansion of once local PEO into state, regional and national markets. By looking closely at the various reasons for failures in new markets and isolating tell-tail signs symptomatic of failure, better client selection criteria can be created. However, it must be remembered, you are dealing with variables and not constants; changes in emphasis, or reasons for failures will occur. Therefore, marketplace monitoring is necessary, and adjustments need to be made accordingly.

 Ongoing Qualifying

Relationships between the PEO and client have changed from a simple payroll/benefits/fee relationship to a partnership, where both parties have a stake in the health and stability of each other. Each is looking for mutual long term benefits from their investment. Therefore, ongoing qualifying can serve 3 basic purposes: 1) determining the viability of the client, 2) feedback from the client for PEO improvements, and 3) PEO interventions for assisting clients.

In order to create an on-going, qualifying capability requires establishing a client feedback/feed forward system; communication mechanisms which permit monitoring client vital signs, and PEO service quality. Some of the information collected during the initial qualifying stage must be continued along with that which may be unique to and indicative of problems in the industry or business type. Also information must be collected from clients about the quality of PEO service, so improvements in product/services, sales and service personnel and management can occur.

Establishing such a system is not free; it is a question of cost-benefits. Some sort of feedback for improving services should be implemented with all clients. However, for selected high risk clients continual in-depth qualifying, perhaps auditing, should exist; the cost of not doing it can be greater than the cost of doing it! The opportunity for open communication can help identify and resolve many potential problems before they mushroom, and also help establish a long-term trusting relationship.

In addition, continual client qualifying can provide an opportunity for PEO timely intervention with assistance. Certain types of intervention could well be new product/services which generate additional revenues for the PEO, while others may be provided by other companies such as banks or management consultants. Moreover it is possible PEOs might see opportunities to purchase such entities and "spin off" different businesses.

In conclusion, as you reflect on the above information, ask yourself the question ... "Where does my PEO stand relative to risk ... success or failure? Is your PEO rolling the dice?