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Published: October 14, 2011

 
 

The Impact of Bankruptcy Laws on Startups

An easier way out prompts more entrepreneurs to get in.

Title: How Do Bankruptcy Laws Affect Entrepreneurship Development around the World? (Subscription or fee required.)

Authors: Seung-Hyun Lee (University of Texas at Dallas), Yasuhiro Yamakawa (Babson College), Mike W. Peng (University of Texas at Dallas), and Jay B. Barney (Ohio State University)

Publisher: Journal of Business Venturing, vol. 26, no. 5

Date Published: September 2011

Entrepreneurship is widely recognized as one of the most important drivers of economic growth. But it’s also risky: The majority of new ventures fail, and many end in bankruptcy. Given that track record, when entrepreneurs consider a new international market, they regularly weigh such factors as logistics and differences in cultural attitudes and financial regulations.

But according to this paper, business owners would do well to also consider another crucial but potentially uncomfortable issue: Are the country’s bankruptcy laws friendly or onerous to entrepreneurs? Bankruptcy regulations vary from country to country in the scope of their protections, and the differences often reflect cultural beliefs. For example, a country that has a risk-averse culture is more likely to have bankruptcy laws that increase the cost of entrepreneurial failure.

This paper explores whether a country’s bankruptcy rules affect its level of entrepreneurial activity — specifically, whether having regulations on the books that are relatively forgiving of failed ventures encourages new firms to open for business. By finding a link between “friendly” bankruptcy laws and increased entrepreneurship, the authors conclude that entrepreneurs should pay close attention to the nuances and vagaries of bankruptcy rules around the world and, if possible, target jurisdictions that will be more understanding if things go wrong. Many variables are involved, but the key factors to consider, the authors say, relate to the cost, timing, and level of debt relief.

“Overall, a more efficient bankruptcy procedure may encourage more entry of new firms,” the authors write. “In Silicon Valley, this is known as the motto of ‘fail fast, fail cheap, and move on.’ ”

The researchers examined data spanning 19 years, from 1990 through 2008, for 29 countries, ranging from fully developed economies like the United States, Germany, and Japan to such emerging economies as Chile and Thailand. Besides analyzing bankruptcy filings from government and private sources, the researchers examined the legal rules protecting creditors. Additional data was culled from the World Bank, the Organisation for Economic Co-operation and Development, the World Health Organization, and the International Monetary Fund (IMF).

Five components of bankruptcy regulations were analyzed. First, the researchers looked at the time it takes to go through a bankruptcy procedure, both for liquidation, which results in the closing of a business, and for reorganization, under which a distressed company is shielded for a time from its creditors as it tries to come up with a new plan to continue operating. A quick process for liquidation acts as a stimulus for entrepreneurship because it allows for the speedy reallocation of a failed firm’s assets, including its people, for better uses and new opportunities. Similarly, when a firm files to reorganize (under the protection of such bankruptcy laws as Chapter 11 in the United States), a fast-moving procedure may protect the value of its assets and improve the odds for a turnaround.

On the other hand, a lengthy process with an uncertain outcome could well add to the financial distress of a struggling company and serve as a powerful disincentive for those thinking of opening up shop. In Japan, even the bankruptcy filings of financially insolvent firms are scrutinized closely in the courts, and some aren’t allowed to proceed. The countries in the study that took the longest to wrap up an average bankruptcy case were Chile (5.5 years), Turkey (3.3 years), and Denmark (3.2 years). The fastest average times were in Ireland (0.4 years), Canada (0.8 years), and Belgium (0.9 years).

 
 
 
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