Failure is an Option: Failure Barriers and New Firm Performance

By Robert Eberhart Charles E. Eesley Kathleen M. Eisenhardt
July12014| Working Paper No. 3308

This study investigates the affect on new venture performance after a regulatory change that motivated the entry of more elite founders because bankruptcy consequences were moderated. Prior research on policy efforts to stimulate entrepreneurship has focused on the motivations and resources available at the beginning of a venture. While this literature has focused on formation rates, the forces that lead to the founding of successful ventures remain elusive. Our study, in contrast, tries to uncover the forces that would motivate the formation of more successful venture by motivating elite founders to start venture. We develop a concept of “failure barriers”, the lowering of which can stimulate venture formation among high human and social capital individuals because they are more affected by bankruptcy consequences since they have more at risk and have better alternative opportunities. To test our theory, we take advantage of a natural experiment in Japan where changes to bankruptcy laws reduced the consequences of closing a firm. We find that: a) high human and social capital entrepreneurs form an increasing proportion of the new firms, b) new firm performance increases as these high human and social capital entrepreneurs are more likely to found higher performing firms, and c) that new firm performance variability increases. While prior research emphasizes the lowering of entry barriers, and that lenient bankruptcy laws are detrimental to new firm performance, our work suggests that reducing the consequences of bankruptcy affects new firms performance through its heterogeneous effect on potential entrants depending on their status. Overall, we find that legal reforms that reduce failure barriers encourage “better”, not just “more”, entrepreneurs to found ventures.