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(originally published by Booz & Company)


The Impact of Bankruptcy Laws on Startups

The second element that was analyzed, the cost of bankruptcy procedures, also differs greatly around the world. A World Bank study in 2008 found that in the United States, the direct cost of bankruptcy is about 7 percent of a firm’s assets. But it costs 22 percent in Italy and Poland, and 36 percent in Thailand. These high costs could discourage firms from filing for bankruptcy even when, at the societal level, it would be more valuable for them to go under so that their resources could be diverted into more profitable channels. And when the costs are high, some entrepreneurs may not want to even start a business.

The third aspect studied by the researchers involved debt relief. Countries’ laws differ in that they can either relieve bankrupt entrepreneurs of their outstanding debt or permit creditors to pursue them for years. In the former case, “fresh start” provisions in a liquidation bankruptcy protect an entrepreneur’s future earnings from old claims. Similarly, these provisions keep varying percentages of a liquidating firm’s assets out of the reach of creditors, allowing a struggling entrepreneur to use the exempt assets in a new venture. In contrast, until recent reforms, German legislation dictated that those in arrears would remain liable for unpaid debt for up to 30 years, and managers at bankrupt firms could be charged with criminal penalties. “For executives of firms in distress who know that the consequences of bankruptcy would hurt them personally, filing a bankruptcy is likely to be the last thing they have in mind,” the authors write.

In analyzing the fourth element, the researchers looked at whether a country’s bankruptcy laws included an automatic “stay of assets” during reorganization — meaning that creditors must stop debt collection efforts and instead take their claims to court while the firm continues to operate. A stay is guaranteed in the United States under Chapter 11, but not in Germany, Great Britain, or Japan.

Finally, the researchers considered the role of managers at bankrupt firms. For example, Chapter 11 in the United States allows incumbent managers to keep control and propose reorganization plans; in Great Britain and Germany, however, that role is handed over to secured creditors. The restrictive approach has been criticized for leading to premature liquidations — and for inhibiting the launch of startups in the first place. “When entrepreneurs know that they would not be given a second chance to revive their firms under difficulty, some of them may be discouraged [from starting] new businesses,” the authors say. On the other hand, allowing failed managers to stay on may just give them another chance to decrease the firm’s value.

In their analysis, the researchers controlled for several factors, including a country’s general level of development and macroeconomic performance as measured by the IMF. In addition, to account for the stability of a country’s financing system, they controlled for the interest rate and the number of banks per capita in operation in a given year.

The researchers found that the less time and cost associated with bankruptcy proceedings, the higher the rate at which new firms were launched. Similarly, the more assets entrepreneurs were able to keep from creditors after a liquidation, the higher the startup rate.

But the researchers also found that allowing a guaranteed stay of assets in reorganization bankruptcy, which typically takes longer than liquidation, did not mean that more new firms popped up — instead, there was an 8 percent decrease in entrepreneurial activity. If debt holders know they may face a long battle for repayment, the authors reason, they will increase the cost of financing, which in turns drives down the number of new businesses. Overall, the researchers found no significant impact on entrepreneurship activity when incumbent managers were allowed to stay or made to leave — although they note that previous research has shown that the managers who are associated with an entrepreneurial firm’s downfall are not always the best people to rescue it.

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