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).
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.
Entrepreneur-friendly bankruptcy laws encourage new businesses to take more risks and broaden their plans, the researchers say. This, in turn, increases the number of firms with high growth potential, but also increases the number of potential failures. The ultimate outcome is worth the effort, the authors say. “Failure, although painful for individual entrepreneurs, may be good — for the economy,” they conclude.
The less risk involved in filing for bankruptcy, the more new firms are founded. Because bankruptcy laws vary widely around the world, especially as they relate to the cost, timing, and level of debt relief, entrepreneurs should closely study the rules in any potential new market.