FAILURE IS AN OPTION: FAILURE BARRIERS AND NEW FIRM PERFORMANCE

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1 FAILURE IS AN OPTION: FAILURE BARRIERS AND NEW FIRM PERFORMANCE EVIDENCE FROM JAPAN ROBERT EBERHART CHARLES EESLEY KATHLEEN EISENHARDT DEPARTMENT OF MANAGEMENT SCIENCE AND ENGINEERING STANFORD UNIVERSITY OCTOBER 2012

2 MOTIVATION National efforts to increase entrepreneurship Startup America Gründerland Deutschland Startup Visa Canada Innovation Britain Startup Chile Yet, we have little evidence that such efforts lead to higher performing firms or economic growth In fact, some evidence shows that they may lead to more low performing firms (Nanda, 2011)

3 GENERAL INQUIRY: INSTITUTIONAL CHANGE AND NEW FIRM PERFORMANCE We know: Lowering institutional entry barriers increases new firm formation - - Lowering increases firm formation through reduced obstacles - (Klapper, Laevena, & Rajan, 2006). - (Hsu, Roberts, & Eesley, 2007) Changing certification and legitimacy, liability of newness - (Sine, Haveman, & Tolbert, 2005)

4 GENERAL INQUIRY: INSTITUTIONAL CHANGE AND NEW FIRM PERFORMANCE We also know: Changing institutional structures affects the kind of entrepreneur - - Releasing opportunity in new or restricted industries a\racts elites - (Eesley, 2010) How firms fail affects new firms causing others to have more resources or opportunities successful - (Hoetker & Agarwal, 2007)

5 RESEARCH AGENDA But there is a gap in our knowledge: We understand institutional effects on: Foundation survival performance in an unchanging environment But subsequent performance (sales growth) after institutional change not so well studied the focus of entrepreneurs affected by the institutional environment but less well studied (Tolbert, David, & Sine, 2010) Performance is the focus of policy if policy is about jobs

6 MY RESEARCH Institutional change on new venture performance Failure Barriers bankruptcy law effect on individual choice effect on firm performance Success Barriers IPO listing requirements effect on individual choice effect on firm strategy and performance

7 JAPAN AS A REFORM LABORATORY Efforts in Japan to increase entrepreneurship Preferential tax rates Lowered patent fees Subsidies for foreign firms Innovation alliances between firms and universities Incubation facilities Hands on advice Government VC and VC subsidy Regional direct gov t investment Bank loans interest support and principal guarantees Green innovation Award and publicity Tourism Tourism?

8 RELATED RESEARCH INSTITUTIONS AND FIRM FORMATION Changes in the institutional environment can alter the rate of venture founding Encouragement Policy Social changes (Aldrich, 1999; Dobbin & Dowd, 1997; Romanelli, 1989; Sine & David, 2003; Sine, Haveman, & Tolbert, 2005; Tolbert, David, & Sine, 2010) Changes in the institutional environment may alter who chooses to become entrepreneurs Different human capital of entrants Legitimacy and expectation of returns (Eesley, 2010; Hsu, Roberts, & Eesley, 2007; Peng, Yamakawa, & Lee, 2009)

9 Previous Research INSTITUTIONS AND FIRM FORMATION Founding and failure are linked Failure in one sector increases founding in another (Hiatt, et al., 2009) Resources of failed firms recycled into new firms death hurts but is not fatal (e.g., Hoetker & Argawal, 2007)

10 Summary of Prior Research We know: Government reforms to the institutional environment that lower entry barriers can increase rate of firm formation Government reforms to the institutional environment that lower growth and failure barriers can shift the mix of who starts firms Failure and founding of firms are often intertwined

11 Open Questions We do not know: How do government reforms influence new firm performance? Highly relevant to job creation and economic growth How are founding, failure, types of entrepreneurs, and performance related? Relevant to how government reforms actually work

12 RESEARCH QUESTION Does lowering the barrier to failure affect the performance of new ventures?

13 FOCUS ON JAPAN REFORM Bankruptcy Reform " Japanese Bankruptcy before 2001 was harsh " 2000 Civil Rehabilitation law " 2003 Corporate Reorganization Law " Effects: " Faster, rational resolution " Protected personal assets " Possible for management to stay in place

14 Hypothesis 1: Failure Effects HYPOTHESIS 1: Institutional reforms that lower failure barriers increase the likelihood of bankruptcy, particularly by elite entrepreneurs Corporate Reorganization Law of 2003 lowered the time, effort, cost, and personal consequences of bankruptcy Effects: the law is likely to increase the rate of bankruptcy by lowering the threshold of firm performance below which executives are likely to dissolve their firms Since elite entrepreneurs (i.e., superior human and social capital) have more at risk including personal assets and reputation, they are less likely to file for bankruptcy when bankruptcy law is punitive Elites preferences are more likely to file for bankruptcy because they have better and more career alternatives than other entrepreneurs

15 Hypothesis 2: Founding Effects HYPOTHESIS 2: Institutional reforms that lower failure barriers increase the likelihood that elite individuals will start new firms Push Pull Entrepreneur Mechanism Less elite entrepreneurs are more likely to start firms when entry barriers fall because they have fewer and less attractive career alternatives to entrepreneurship and less at risk than elites. They are pushed into entrepreneurship Conversely, elite entrepreneurs are less affected when entry barriers fall because they have many and better career alternatives and more at risk than others. They are unlikely to be pushed into entrepreneurship by necessity. Rather, they are likely to be pulled into entrepreneurship by attractive opportunities Elite entrepreneurs are particularly likely to be influenced by reducing failure barriers because the reduction of risk disproportionately influences individuals who face very high risk. Thus, elite individuals are uniquely incentivized to start firms if they have the desire through lowered bankruptcy consequences.

16 Hypothesis 3: Performance Effects HYPOTHESIS 3: Institutional reforms that lower failure barriers increase the performance of new firms IF elite entrepreneurs are more likely to start firms when failure barriers are lowered, then: Elite entrepreneurs are more likely to start firms that become higher performing because these entrepreneurs have Higher human capital (Baron & Ensley, 2006; Eesley & Roberts, 2009; Eisenhardt & Schoonhoven, 1990) Higher social capital (Hallen 2008; Stam & Effring, 2008; Stuart et al., 2009) These advantages are likely to lead elite entrepreneurs to pursue better entrepreneurial opportunities and manage more effectively In Japan, elite founders typically have attended top universities and are older both of which enhance both human and social capital Thus, the higher rate of entry of elite entrepreneurs is likely to lead to higher performing ventures

17 METHODS Quasi-natural experiment Japanese bankruptcy reform in 2003 Sample consists of approximately 16,000 Japanese corporations from Teikoku Databank (leading Japanese credit agency) Founded , Robustness for founded and No subsidiaries No non-operating companies (i.e., no sales or no employees) Eliminated firms without founding information no significant differences TDB is accurate data source often used by Japanese scholars

18 VARIABLES Dependent variables Panel logit regressions on bankruptcy, DV = bankruptcy event Logit regressions on entry DV = founding after reform Differences in-differences OLS on firm performance, DV= CAGR Independent Variables Elite entrepreneur: attended leading university binary variable (=1 if top 10) CEO age at founding Post-reform founding - binary variable (=1 if founded after 2002) Controls (initial and time-varying conditions) Initial capitalization (constant 2009 Y) Initial industry (6 categories, base = primary industry) Initial macroeconomic environment (log GDP/capita in 3 year window around founding year) H1 &3: Age (years since founding) H1: Post-reform existence (=1 if alive for each year after 2002) H2 & H3: Post-reform founding (=1 if founded after 2002) H3: Managerial skill (firm credit rating) H3:Competition (# of firms in industry)

19 BANKRPTCY results DV = bankruptcy event (Panel logit): Controls as expected for macroeconomic environment and age H1 confirmed more bankruptcy events after reform, especially by elite entrepreneurs

20 INTERACTION EFFECTS Interaction Effect Elite: Univ. Alum vs Reform (95% significance CI) Bankruptcy Likelihood No Ref Reform Elite Coll Not Elite

21 INTERACTION EFFECTS

22 FOUNDING RESULTS DV = founding after 2002 (Logit model): Controls as expected for macroeconomic environment H2 confirmed elite entrepreneurs more likely to found firms after bankruptcy reform

23 OLDER

24 AND BETTER EDUCATED

25 PERFORMANCE results DV = Cum Avg. Sales Growth after founding (Diffs-in-Diffs OLS model): Controls as expected H3 supported Elite entrepreneurs found higher performing firms, especially after reform

26 PERFORMANCE BEFORE AND AFTER REFORMS

27 GROWTH WAS IGNITED

28 Robustness of Findings Alternative sampling: foundings, foundings Findings consistent with primary analysis Alternative specification of reform year: Findings consistent with primary analysis such that other years do NOT produce the same results as the focal reform year

29 FINDINGS After reforms lowering failure barriers: Elite founders started ventures with greater likelihood (H1) Elite founders are likelier to take advantage of opportunities to found high performing firms (H2) Equalization of bankruptcy effects New firms performance increased (H3) Older Elite Educated Social Networks

30 Theoretical Contributions Concept of failure barrier and its implications for different types of entrepreneurs failure barriers more likely to influence the elite Implications of institutional reforms for firm performance failure barriers likely to influence firm performance Richer understanding of interrelationships: founding, failure, types of entrepreneurs and performance

31 Policy Insights Bankruptcy law is powerful institutional lever to promote economic growth Lowering entry barriers may increase firm formation but lowering failure barriers attracts the elite to start firms Motivating elite individuals to become entrepreneurs is central to effective policies for economic growth through entrepreneurship

32 OVERALL Lowering entry barriers determines whether you can start a firm Lowering failure barriers determines whether you want to start one.

33 THANKS