Researchers at Stanford have found that making bankruptcy laws less punitive motivates the most promising entrepreneurs to start successful businesses. The new study introduces the concept of a “failure barrier” and how lowering it can yield powerful and positive economic results.
Experts in Stanford’s Department of Management Science and Engineering (MS&E) studied entrepreneurial activity in Japan before and after the nation reformed its bankruptcy laws in 2003. The laws went from being a mechanism for punishing poor managers and forcing debt recovery, to a more forgiving set of policies that allowed executives to keep their jobs and reorganize their failed firms.
The study’s authors found that the rate of firms launched by “elite” entrepreneurs more than doubled after the overhaul. They also reported that firms launched a year after the policy change grew 44 percent faster than similarly aged firms founded prior to the overhaul — and that the highest-performing firms were founded post-reform.
The study’s insights into the mechanisms of new-firm growth represent a unique contribution in the area of entrepreneurship research. The findings also have implications for government policy: showing that bankruptcy reform can spur economic activity, as well as motivate the “best” — not just the most — individuals to become entrepreneurs.
“We found that the regulations and beliefs that only directly affect firms at the end of their lives, profoundly affect how new companies form, who forms them, and increased their early performance,” said Robert Eberhart, a research scholar in MS&E, a department in Stanford’s School of Engineering.
Co-authors of the study include Chuck Eesley, an assistant professor in MS&E, and Kathleen Eisenhardt, the Stanford Warren Ascherman M.D. Professor in MS&E. Both Eesley and Eisenhardt are on faculty at the Stanford Technology Ventures Program (STVP).
Eberhart leads the Stanford Project on Japanese Entrepreneurship, which aims to better understand the global implications of a new entrepreneurial dynamic in the world’s third largest economy. The project is based at STVP and Stanford’s Graduate School of Business.
“We found that the regulations and beliefs that only directly affect firms at the end of their lives, profoundly affect how new companies form, who forms them, and increased their early performance.”
Previous studies have shown how lowering the barriers to entry for entrepreneurs — providing subsidies and streamlining procedures, for instance — results in more people across the board starting their own businesses. This latest research looks at a different aspect by focusing on “failure barriers,” such as making bankruptcy laws less punitive.
The Stanford researchers say that lowering such barriers can be particularly effective for motivating more educated and experienced individuals to start their own companies. As other studies have shown, this group of entrepreneurs is more likely to launch high-performing ventures — and so, policies that support those entrepreneurs should be a high priority.
In their study, the authors say the rate of firms formed by elite entrepreneurs — those who graduated from one of Japan’s top universities and were over the age of 40 — more than doubled after bankruptcy laws were reformed.
The study is also unique in that it encompasses the more complex and realistic ecosystem that encompasses business failures, the founding of new firms, types of entrepreneurs and other factors. For instance, making bankruptcy less punishing can prompt elite entrepreneurs to leave marginal firms and start new ones — even leveraging the assets of failed businesses to strengthen theirs.
“… bankruptcy law is a powerful policy lever available to governments because it motivates the best qualified individuals who are most likely to succeed to become entrepreneurs.”
Indeed, the study’s authors say that lawmakers looking to spur entrepreneurial activity would do well to make failure less daunting for elite individuals — as they risk the most, and are the ones more likely to launch successful, job-creating companies that are the darlings of public policy.
“We found that bankruptcy law is a powerful policy lever available to governments because it motivates the best qualified individuals who are most likely to succeed to become entrepreneurs,” the authors conclude. “Lowering failure barriers is thus the ‘other side of the coin’ from lowering the growth barriers that ‘pull’ elite individuals into starting firms.”
Understandably, just as the rate of companies founded by elite entrepreneurs increased after Japan reformed its bankruptcy laws, the likelihood of them declaring bankruptcy also rose, the authors reported.
But they also assert that, if entrepreneurship is part of the “perennial gale of creative destruction” that propels an economy forward, governments can “strengthen” that gale by adopting laws that reasonably minimize penalties when entrepreneurs fail.
The study was funded and supported by The Miner Foundation, Michael Alfant, Cisco Systems, and Best Buy, Inc.