Bankruptcy Law And Entrepreneurship Development A Real Options Perspective Seung-hyun Lee

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Bankruptcy Law And Entrepreneurship Development A Real Options Perspective Seung-hyun Lee

BANKRUPTCY LAW AND ENTREPRENEURSHIP
DEVELOPMENT: A REAL OPTIONS
PERSPECTIVE
SEUNG-HYUN LEE
MIKE W. PENG
University of Texas at Dallas
JAY B. BARNEY
The Ohio State University
We develop a real options perspective to explore how an entrepreneur-friendly bank-
ruptcy law can encourage entrepreneurship development at the societal level. If
bankrupt entrepreneurs are excessively punished for failure, they may let inherently
high-risk but potentially high-return opportunities pass. We suggest that a more
entrepreneur-friendly bankruptcy law, informed by a real options logic, can encour-
age more active and vibrant entrepreneurship development. We also discuss the
implications of the role of venture capital and stigma in the effectiveness of an
entrepreneur-friendly bankruptcy law.
Interest continues to grow in understanding
how entrepreneurship can create value in a so-
ciety. Much of this interest focuses on the role of
risk taking by entrepreneurs and managers in
creating economic value and, in particular, how
barriers to the entry of entrepreneurs into the
economy can be lowered (Busenitz, Gomez, &
Spencer, 2000; Djankov, La Porta, Lopez-De-
Silanes, & Shleifer, 2002). There is, however, rel-
atively little work on how to lower barriers to
exit business, such as bankruptcy laws.
Corporate bankruptcy is very common. In-
deed, hundreds of thousands of firms around the
world declare bankruptcy each year. During the
1990s, the annual average number of corporate
bankruptcies in Japan was 14,500 (Industry
Week, 1998), in France 52,000, in Great Britain
47,000, and in Germany 21,000 (Claessens &
Klapper, 2005). In 2001, 38,540 businesses in the
United States declared bankruptcy (American
Bankruptcy Institute, 2003). Many of these bank-
ruptcies are filed by entrepreneurial firms. For
example, White (1990) shows that 46 to 60 per-
cent of U.S. firms that filed for bankruptcy from
1950 to 1987 were young firms, five years old or
younger. Warren and Westbrook (1999) report
that 80 percent of U.S. firms that filed for bank-
ruptcy reported assets under $1 million, and 88
percent reported having fewer than 20 employ-
ees.
Despite the frequency of corporate bankrupt-
cies, the legal procedures associated with bank-
ruptcy vary significantly across countries. Some
countries define only a few types of bankruptcy
and provide limited protection for entrepreneurs
and managers of bankrupt firms. Other coun-
tries have many more bankruptcy options,
which vary in the extent to which they limit the
personal liability of entrepreneurs and manag-
ers of bankrupt firms.
More generally, bankruptcy law is an impor-
tant example of the broad institutional context
within which firms in a country operate (North,
1990; Peng, 2003, 2005, 2006; Scott, 1995). This in-
stitutional context includes all the formal and
informal rules in a society that affect organiza-
tions as players. Thus, in the case of bankruptcy,
a country’s institutional context includes not
only bankruptcy law but also social norms
about bankruptcy, the structure of capital mar-
This article draws on the first author’s dissertation at The
Ohio State University. This research was supported in part
by the OSU Graduate School and a National Science Foun-
dation CAREER Grant (SES 0552089). Earlier versions were
presented at the annual meeting of the Academy of Man-
agement (Denver, 2002) and at the OSU Fisher College of
Business (2002). We thank Asli Arikan, Ilgaz Arikan, Mona
Makhija, Oded Shenkar, Ken Smith (guest editor), Heli
Wang, and three anonymous reviewers for helpful com-
ments and discussions. Jessica Zhou provided able assis-
tance. The views expressed are those of the authors and not
necessarily those of the funding organizations.
? Academy of Management Review
2007, Vol. 32, No. 1, 257–272.
257
kets, and broadly held personal beliefs about
responsibility.
Most research on the institutional context
within which firms operate focuses on the impli-
cations of these institutions on the strategic
choices of firms (Meyer & Peng, 2005; Peng, 2003,
2005, 2006; Peng, Lee, & Wang, 2005; Wright, Fila-
totchev, Hoskisson, & Peng, 2005). While ac-
knowledging the importance of these firm-level
effects, our central purpose here is to examine
the broader, societal-level economic conse-
quences of these institutions, using bankruptcy
as a focal point. In particular, we examine the
impact of institutions associated with bank-
ruptcy on the willingness of individuals in a
society to engage in risk-taking entrepreneurial
activity. By adopting these societal effects as a
dependent variable, we examine the relation-
ship between the institutions associated with
bankruptcy and value-creating activities in a
society associated with risk taking by entrepre-
neurial firms. Here, we define entrepreneurs as
individuals who combine resources in new and
risky ways (Schumpeter, 1942) and who have the
potential to add value to society through these
endeavors.
Our key question is “How does an entrepre-
neur-friendly bankruptcy law affect entrepre-
neurship development at a societal level?” The
theoretical lens we use is real options theory.
We argue that real options theory is highly ap-
propriate here because institutions associated
with bankruptcy determine the maximum down-
side risk associated with risky investments of a
firm, while the upside potential of these invest-
ments is potentially unlimited. This is exactly
the setting within which real options logic can
be applied (Dixit & Pindyck, 1994; McGrath,
1999). Our central argument is that, at a societal
level, an entrepreneur-friendly bankruptcy law,
informed by a real options logic, can encourage
more risk taking and, thus, more entrepreneur-
ship development by limiting downside risks
and increasing upside gains.
REAL OPTIONS AND VALUE CREATION AT
THE SOCIETAL LEVEL
Real Options Theory
Originating from financial options theory
(Black & Scholes, 1973; Dixit & Pindyck, 1994),
real options theory focuses on the real business
application of financial options (Bowman &
Hurry, 1993). In financial options, as uncertainty
increases, upside potential increases while
downside risk remains fixed (Fama & Miller,
1972). This logic also applies to real options. The
higher the variance in outcome from making a
real investment, the higher the option value of
the investment (McGrath, 1999).
Real options are important because they rep-
resent a portion of the value of future opportu-
nities that cannot be explained by the present
value of future cash flows. To date, real options
theory has been applied to different aspects of
management research, including multinational
flexibility (Reuer & Leiblein, 2000), joint ventures
(Kogut, 1991; Tong, Reuer, & Peng, in press), di-
versification (Kim & Kogut, 1996), governance
structure (Folta, 1998), and entrepreneurship de-
velopment (McGrath, 1999).
1
A Real Options Perspective on the Societal
Level
Although McGrath (2001) observes that real
options theory can be applied at a societal level,
most past research on real options has focused
on the firm level. However, there is a long tradi-
tion of entrepreneurship research—probably
dating back to Schumpeter (1942)—that focuses
on the societal level. Scholars generally agree
that entrepreneurship development, by encour-
aging economic and competitive variety, can
add value to a society (Birley, 1986; Lumpkin &
Dess, 1996). There also exists some entrepre-
neurship research using societal-level institu-
1
Recent debates on real options theory (e.g., Adner &
Levinthal, 2004; McGrath, Ferrier, & Mendelow, 2004) show
that there are many different points of view on real options.
In this article we follow McGrath’s (1999) argument: real
options can be thought of as an analogy, emphasizing two
characteristics: (1) options are best valued when each option
is considered as part of a bundle, and, thus, a higher vari-
ance in a bundle of options increases the value of options; (2)
in a real options lens, the key is not avoiding failure but
managing the cost of failure by limiting exposure to down-
side risk while preserving upside gains. Along these lines,
Gavetti and Levinthal (2000) also emphasize that
if low-outcome draws can be costlessly discarded, then
greater variance in the sample, holding the mean con-
stant, increases the expected value of those that are
adopted. This is the basic intuition behind the recent
interest in the idea of “real options” in the business
strategy literature (Bowman and Hurry, 1993) (2000:
115).
258 January Academy of Management Review
tions as an independent variable to predict en-
trepreneurial behavior (Baumol, 1990; Busenitz
et al., 2000; Van de Van, 1993).
Focusing on bankruptcy law, we leverage in-
sights from real options theory and integrate
them with the tradition of societal-level entre-
preneurship research. We argue that when risk
taking is encouraged via a more entrepreneur-
friendly bankruptcy law, a society will be char-
acterized by the creation of more real options by
entrepreneurs. Specifically, such laws may gen-
erate variety by increasing the number of firms
with high growth opportunities and decreasing
the number of failing firms, both of which may
be a key to value creation at the societal level.
There are at least two rationales for this per-
spective. First, options are best valued when
each option is considered as part of a bundle.
When an economy composed of different firms is
understood as a bundle of options, each firm no
longer stands alone (Bowman & Hurry, 1993).
Rather, it is part of a bundle of options in a given
society (McGrath, 1999). Therefore, a higher vari-
ance in a bundle of options, even though some
individual firms within the bundle may fail, may
be desirable. We extend this notion by showing
how different bankruptcy law arrangements
might encourage or discourage the risk-taking
tendency of firms within a society.
Second, failure, although painful for bankrupt
entrepreneurs and firms, can be beneficial for
the society as a whole. The decision to take a
risk implies embracing all that goes with this
decision, especially the risk of possible failure
(Miller & Reuer, 1996; Venkataraman, 1997). From
a real options lens, “the key issue is not avoid-
ing failure but managing the cost of failure by
limiting exposure to the downside while pre-
serving access to attractive opportunities and
maximizing gains” (McGrath, 1999: 16). There-
fore, in real options reasoning, a high failure
rate can even be a good thing for a given soci-
ety, on the condition that the cost of failure is
contained. Past research shows that a high fail-
ure rate of firms actually goes hand in hand
with economic growth of a society (Birch, 1979).
Overall, “to avoid encouraging passivity, a
society or firm would be better off using mech-
anisms that share the costs of entrepreneurial
failure, rather than heaping financial and social
sanctions upon those who explore entrepreneur-
ial options” (McGrath, 1999: 25). Since different
institutional arrangements can influence the ex-
tent of entrepreneurship development (Barro,
1997; Peng & Zhou, 2005), formal institutions such
as bankruptcy law can have a significant influ-
ence on the decision to create a firm—a decision
that can add value in a society.
RISK TAKING, ENTREPRENEURSHIP
DEVELOPMENT, AND POSITIVE
EXTERNALITIES
Bhide (2000) argues that the really significant
risk for a venture occurs not at the start-up stage
but at the point when major irreversible invest-
ment in growth is required. At this stage, an
entrepreneur puts all of his or her financial re-
sources into “one basket.” Bhide argues that
“growth involves developing formal structures
and systems that increase the firm’s fixed costs
and hence the risk of bankruptcy” (2000: 293;
emphasis added). Whether entrepreneurs esca-
late their commitment at this stage—in the face
of increasing bankruptcy risk—often deter-
mines whether their firms will eventually suc-
ceed or not.
In the aggregate, if more entrepreneurs are
willing to take such risks, then there will be a
wider variety of firms and, in turn, a higher level
of competition in a society. Moreover, not only
may these entrepreneurial firms take risks but
they also may induce risk-averse established
firms to take more risks (Arend, 1999) in order to
avoid becoming competitively obsolete.
Of course, individuals in a society vary in the
extent to which they are risk averse, risk neutral,
or risk seeking (Begley & Boyd, 1987; Busenitz &
Barney, 1997; Low & MacMillan, 1988). In socie-
ties with bankruptcy laws that are not entrepre-
neur friendly, only those individuals who are the
most comfortable with risk will be willing to
make these significant firm-specific invest-
ments. In societies with more entrepreneur-
friendly bankruptcy laws, people who are either
risk seeking or risk neutral may be willing to
engage in entrepreneurial behavior. As the per-
sonal costs of failed entrepreneurial activities
are reduced, the number and variety of people
pursuing entrepreneurial activities will in-
crease, and society, on average, will benefit.
It has been widely documented that competi-
tion leads firms to be more innovative (Mitchell,
1989; Porter, 1990) and that variety, which fosters
experimentation, leads a society to reap positive
gains through innovation (Diamond, 1997; Feld-
2007 259 Lee, Peng, and Barney
man & Audretsch, 1999; Knott, 2003). Entrepre-
neurship can generate positive externalities—
the positive, value-adding effects that the action
of a group of firms has on other firms and society
at large (Arrow, 1962; Barro, 1997; Birley, 1986;
Rosenberg & Birdzell, 1986). This is why Miles,
Snow, and Sharfman argue that “both corporate
strategies and government policies should focus
on variety as a means of achieving both com-
pany and industry success” (1993: 164; emphasis
added).
At the same time, firm exit is also a necessary
condition for economic growth. Empirical evi-
dence suggests that when innovative activity in
an industry increases, firms’ overall survival
rates often decrease, but those that do survive
tend to be stronger (Audretsch, 1991; Porter,
1990). “Perhaps competition works not by forcing
efficiency on individual firms but by letting
many flowers bloom and ensuring only the best
survive” (Nickell, 1996: 741). For example, Lim
and Han (2003) show that bankruptcy reforms in
South Korea after the 1997 economic crisis con-
tributed to productivity growth by allowing in-
efficient firms to exit, encouraging new entries,
and stimulating surviving firms to become more
efficient. In other words, higher competition
spurred by lower downside risk and lower bank-
ruptcy cost would force inefficient firms to exit
(Ahlstrom & Bruton, 2004). If bankruptcy costs
were higher, inefficient firms would be reluctant
to file bankruptcy and would continue to operate
at a financial loss.
2
Overall, looking at positive externalities be-
yond individual firm boundaries, many failed
first movers (such as de Haviland in jet airliners,
EMI in CT scanners, and Webvan in online-
based grocery delivery) are the sources of en-
tirely new industries (Aldrich & Fiol, 1994;
Lieberman & Montgomery, 1998). The pursuit of
opportunities by many entrepreneurs may result
in having key uncertainties resolved more rap-
idly and less expensively (on a per firm basis
and a societal basis) than if only a few entrepre-
neurs are in the game (Diamond, 1997; McGrath,
1999). These dynamics can be affected by bank-
ruptcy law in a society.
BANKRUPTCY LAW FROM A REAL OPTIONS
PERSPECTIVE
Given that institutions are usually defined as
“the rules of the game in a society” (North, 1990:
3; Peng, 2003, 2006; Scott, 1995), bankruptcy law
can be regarded as the “rules of the end game.”
In a society, the purpose of bankruptcy law is to
resolve conflicts that may arise among creditors
when a firm becomes insolvent (Jackson, 1986).
In the absence of bankruptcy law, even when
coordinated liquidation would maximize the re-
turns to the creditors as a group, each creditor
has an incentive to collect the debt privately
before other creditors do. Because the firm’s as-
sets are sold in an ad hoc approach, the result-
ing first-come, first-served ordering of creditors’
claims will prompt an inefficient liquidation
(Longhofer & Peters, 2004). Jackson argues that
the rational decision by numerous individual
creditors
may be the wrong decision for the creditors as a
group. Even though the debtor is insolvent, they
might be better off if they held the assets to-
gether. Bankruptcy provides a way to make these
diverse individuals act as one by imposing a
collective and compulsory proceedings on them
(1986: 12–13).
A real options perspective identifies how dif-
ferent institutional arrangements such as bank-
ruptcy law provide incentives and disincentives
for entrepreneurship development. First, a bank-
ruptcy law can generate ex post barriers to exit.
When these barriers are unfavorable to entre-
preneurs (such as not being able to walk away
from a heavy debt load), they may try, by all
means, to avoid business exit. In any economy,
letting some failing firms exit is essential to
societal-level economic health (Ahlstrom & Bru-
ton, 2004; Khanna & Poulsen, 1995). To the extent
that a market economy can be characterized by
a permanent flow of resources from inefficient
users to more efficient users, failing firms, if
they do not exit, will continue to consume re-
sources that could have been put to more pro-
ductive use (Hamao, Mei, & Xu, 2002). In Spain,
firm exits actually have a positive impact on
total industry factor productivity (Callejon & Se-
garra, 1999). In post 1997 Asia, similar findings
have been reported (Ahlstrom & Bruton, 2004;
Carney, 2004; White, 2004). Therefore, by lower-
ing exit barriers, an entrepreneur-friendly bank-
2
Even when it is economically more efficient to exit, sur-
viving and remaining in business are often goals from an
individual entrepreneur’s perspective (Gimeno, Folta, Coo-
per, & Woo, 1997). However, at the societal level, it is more
desirable that inefficient firms exit.
260 January Academy of Management Review
ruptcy law can help improve economic effi-
ciency and growth.
Second, an entrepreneur-unfriendly bank-
ruptcy law can, at the same time, create ex ante
barriers to entry by discouraging entrepreneurs
who are afraid of the damaging consequences
of a possible bankruptcy to start up their own
firms (Surlemont, Leleux, & Denis, 1999). Con-
versely, a more entrepreneur-friendly bank-
ruptcy law can facilitate more risk taking by
encouraging the creation of more new firms
(Georgellis & Wall, 2002). For example, approx-
imately 50 percent of American entrepreneurs
who had filed Chapter 7 liquidation bankruptcy
for their start-ups in 1989–1993 resumed a new
venture by 1993 (Landier, 2001). This compares
sharply with countries such as Japan, where it is
often said there is no second chance for entre-
preneurs who have failed once. Therefore, mak-
ing the bankruptcy law more entrepreneur
friendly, such as making it easier to file for
bankruptcy, may actually enhance value cre-
ation via more active entrepreneurship develop-
ment at the societal level (Foley, 2000).
3
In a nutshell, by limiting the downside risk of
failure, an entrepreneur-friendly bankruptcy
law can limit the exit cost ex post. Therefore, it
also indirectly facilitates upside gains by en-
couraging more risk taking ex ante. In the next
section we develop this perspective further.
BANKRUPTCY LAW AND ENTREPRENEURSHIP
DEVELOPMENT
How can an entrepreneur-friendly bankruptcy
law promote entrepreneurship development?
Five aspects are particularly relevant: (1) the
availability of a reorganization bankruptcy op-
tion, (2) the speed of the bankruptcy procedure,
(3) the opportunity to have a fresh start in liqui-
dation bankruptcy, (4) the opportunity to have an
automatic stay of assets, and (5) the opportunity
for managers to remain on the job after filing for
bankruptcy.
Availability of a Reorganization Bankruptcy
Option
For firms in financial distress, there are three
possible ways to approach bankruptcy: (1) out-
of-court settlement, (2) reorganization bank-
ruptcy (such as Chapter 11 in the United States),
and (3) liquidation bankruptcy (such as Chapter
7 in the United States)—see Table 1. Firms usu-
ally resort to out-of-court settlement first, since it
is considerably less expensive than in-court re-
organization (Franks & Torous, 1994). Between
the latter two, U.S. firms often prefer Chapter 11,
since filing Chapter 11 offers one more chance to
revive from financial distress (Lynn & Neyland,
1992). From the real options lens, the chance to
file reorganization bankruptcy provides firms
with more options. This can increase the vari-
ance of different firms in a society. During this
termof bankruptcy protection, restructuring may
enable some firms, in temporary financial dis-
tress, to eventually become successful. This is
why filing reorganization bankruptcy is consid-
ered one of the strategic options for many firms
in financial distress (Flynn & Farid, 1991: 64).
Not all countries have all three ways of resolv-
ing financial distress. For instance, some coun-
tries (e.g., Poland) do not have the option of
reorganization bankruptcy. In some cases, even
though the reorganization option exists, be-
cause of heavy requirements for filing reorgani-
zation bankruptcy, its value is questionable. For
example, in Germany, reorganization bank-
ruptcy is available, but only 0.3 percent of all
financially troubled firms actually use it
(Franks, Nyborg, & Torous, 1996). The vast major-
ity of financially troubled German firms are liq-
uidated without going through reorganization
bankruptcy (Skeel, 1998).
In an environment where reorganization
bankruptcy is unavailable, firms’ options are re-
duced to out-of-court settlement or liquidation
bankruptcy. When firms in financial distress are
forced to liquidate without having an opportu-
nity to restructure, the possible future variety
3
Some might argue that an entrepreneur-friendly bank-
ruptcy law would increase the cost of financing for failed
firms. This, however, is not necessarily true. When the cost of
capital for failed entrepreneurs is high, entrepreneurs only
abandon projects with very poor prospects. This makes it
less probable that capable entrepreneurs fail, and de-
creases the quality of the pool of failed entrepreneurs,
which, in turn, justifies the high cost of capital for failed
firms. When the cost of capital for failed entrepreneurs is
low, however, entrepreneurs tend to continue only those
projects with high prospects. Consequently, at the societal
level, the pool of failed entrepreneurs is of high quality,
which justifies the low cost of capital for failed entrepre-
neurs (Landier, 2001). In a most extreme example, Harvard
Industries filed bankruptcy four times (called Chapter 44) in
the United States, a country where financing cost is low
(Economist, 2002).
2007 261 Lee, Peng, and Barney
might be reduced at the societal level. From a
real options perspective, providing an opportu-
nity for bankrupt firms to reorganize leaves op-
tions open for a society at large. This is why
Miller (1977) argues that the reorganization
bankruptcy option can be considered a “call op-
tion.” Since it is uncertain whether a firm has a
positive future, providing an opportunity to
prove if it has future value is an invaluable
instrument for creating options value at the so-
cietal level. Shareholders will benefit if reorga-
nization succeeds and can walk away should
reorganization fail.
These arguments explain why there is a re-
cent global trend to add U.S. Chapter 11–type
reorganization bankruptcy as one of the choices
for bankrupt firms in many countries, such as
Argentina, Australia, Great Britain, Indonesia,
and Thailand (Stiglitz, 2001). The driving motiva-
tion seems to be to make bankruptcy law less
painful for entrepreneurs.
Proposition 1: The availability of reor-
ganization bankruptcy as a choice for
bankrupt firms (in addition to out-of-
court settlement and liquidation
bankruptcy) will encourage entrepre-
neurship development by curtailing
the downside risk of entrepreneurs.
Speed of Bankruptcy Procedure
The cost of bankruptcy is positively correlated
with the length of time spent on the bankruptcy
procedure (Bebchuk, 2000). In a liquidation bank-
ruptcy, a fast procedure leads to quick realloca-
tion of assets of failed firms to better users. At
the same time, a fast procedure can free an
entrepreneur from a failing business and pro-
vide an opportunity to start a new one. By elim-
inating failing firms and reallocating resources
to better users, a fast bankruptcy procedure in-
creases variance in a bundle of firms at a soci-
etal level.
If a firm filed reorganization bankruptcy, a
fast procedure would protect the asset value of
the firm and improve its odds for a successful
turnaround (Bebchuk, 2000). A lengthy process
characterized by an uncertain outcome might
make business partners (such as buyers and
sellers) reluctant to maintain their business re-
lationship. This, in turn, would reduce earnings
and the value of firm assets (LoPucki & Doherty,
2002). Managers would likely become frustrated
with the long procedure, distracting them from
focusing on operations. In addition, a longer pe-
riod of bankruptcy procedure would send a neg-
ative signal to shareholders, who might believe
that the firm has no hope of survival. All these
increase the odds for an unrecoverable failure
with liquidation as the only viable outcome. In
other words, an inefficient, time-consuming pro-
cedure might end up forcing a firm to liquidate
by increasing financial distress, whereas a fast
procedure might save the firm.
For example, in Japan, even when financially
insolvent firms decide to file for bankruptcy,
courts will examine each case and decide
whether to allow certain firms to declare them-
selves bankrupt. In other words, some insolvent
firms are not allowed to declare themselves
bankrupt. This procedure alone takes more than
three months (Alexander, 1999). Therefore, it is
not surprising that half of all liquidations in
Japan take more than three years and that more
than 75 percent of reorganizations exceed five
years fromapplication to conclusion (Alexander,
1999). In comparison, the bankruptcy procedure
in the United States is more efficient: U.S. courts
automatically accept bankruptcy petitions, and
the average number of days spent on Chapter 11
reorganization bankruptcies during 2000 to 2002
was 296 (WebBRD, 2003). Overall, if the bank-
TABLE 1
Three Types of Bankruptcy
Out-of-Court Settlement Reorganization Bankruptcy Liquidation Bankruptcy
Bankrupt entrepreneurs and creditors
settle out of court. Firm operations
may or may not cease, depending
on the outcome of such
negotiations.
Through court intervention, bankrupt
entrepreneurs and creditors
negotiate to reduce debt
obligations and restructure
operations. Firm operations do not
cease.
Through court intervention,
bankrupt entrepreneurs exit the
firm and creditors claim assets of
the firm. Firm operations cease.
262 January Academy of Management Review
ruptcy procedure is too long and painful, many
entrepreneurs, who otherwise would have filed
bankruptcy for their failing firms, may decide to
procrastinate, at a greater cost to themselves
(erosion of firm value and high opportunity cost
of not being able to pursue other endeavors) and
to society (hindering quick reallocation of re-
sources to more efficient users). Therefore, a
more efficient bankruptcy procedure may en-
courage failing firms to file bankruptcy and, in
turn, stimulate entrepreneurship development.
Proposition 2: Less time spent on the
bankruptcy procedure will encourage
entrepreneurship development by cur-
tailing the downside risk of entrepre-
neurs.
Fresh Start in Liquidation Bankruptcy
From a real options perspective, while in-
creasing the variance in a society is important,
hopeless options should be terminated
(McGrath, 1999). However, since it is impossible
to know a priori which firms should be termi-
nated, it may be better to give all entrepreneurs
an incentive to file bankruptcy if their firms are
failing (Ayotte, in press).
Bankruptcy law can be either discharging the
bankrupt individuals from debt or allowing the
pursuit of bankrupt entrepreneurs for several
years (Organization for Economic Co-operation
and Development, 1998). By simply discharging
bankrupt entrepreneurs, creditors can claim re-
sidual assets but cannot pursue any remaining
claims that have not been met (e.g., as in the
United States). Since future earnings are exempt
from the obligations to repay debt, this is called
a “fresh start” (White, 2001). In the absence of a
legally protected fresh start, creditors can pur-
sue any remaining claims. For instance, in Ger-
many, creditors can go beyond claiming resid-
ual assets, and the debtor remains liable for
unpaid debt for up to 30 years (Ziechmann, 1997:
12–25). German managers at bankrupt firms can
also be personally liable for criminal penalties
(Fialski, 1994). Not surprisingly, such different
rules of the game lead to a huge difference in
risk-taking propensity between American and
German entrepreneurs.
In addition, the recent Asian economic crisis
revealed that little protection against creditors
actually kept many firms from filing bankruptcy,
even when they were heavily losing money (Ahl-
strom & Bruton, 2004; Carney, 2004; New York
Times, 1998; White, 2004). For executives of fail-
ing firms who know that the consequences will
hurt them personally, such as ruining their rep-
utation and inviting possible criminal law suit,
filing bankruptcy is likely to be the last thing
they have in mind. This probably is a key reason
why Chang and Hong (2000), when studying Ko-
rean firms, had to delete 4,141 firms that were
practically bankrupt (with negative equity val-
ues) but did not file for bankruptcy from their
sample of 43,874 firms (close to 10 percent of the
sample). This means that many loss-making
firms continued to survive at a huge cost to the
overall value of the bundle of firms in Korea.
Proposition 3: Discharging bankrupt
entrepreneurs to allow them to have a
“fresh start” specified by a bankruptcy
law, rather than allowing the pursuit
of remaining claims, will encourage
entrepreneurship development by cur-
tailing the downside risk of entrepre-
neurs.
Automatic Stay of Assets in Reorganization
Bankruptcy
Bankruptcy law may entail an automatic stay
of assets and discharge some portion of debt. An
automatic stay upon commencement of bank-
ruptcy proceedings means that creditors must
cease debt collection efforts and direct their
claims to the court (Alexopoulos & Domowitz,
1998). The firm will be in operation while the
creditors and managers negotiate (Kaiser, 1996).
An automatic stay allows time for managers to
communicate with creditors before deciding
whether the firm should be liquidated (Franks et
al., 1996). For example, in the United States,
bankruptcy law stipulates automatic stay in the
case of reorganization bankruptcy. Countries
such as Germany, Great Britain, and Japan,
however, do not guarantee automatic stay of
assets (Alexander, 1999; Hashi, 1997). La Porta,
Lopez-De-Silanes, Shleifer, and Vishny (1998)
have found that nearly half of the forty-nine
countries they studied do not have an automatic
stay on assets.
In an economy where secured creditors can
repossess their assets when a firm files for reor-
ganization bankruptcy, premature liquidations
2007 263 Lee, Peng, and Barney
can result. Given uncertainty over the future
performance of the firm, creditors may have a
greater interest in liquidating the firm, even
when the value of the ongoing concern is higher
than the liquidation value (Wruck, 1990). For ex-
ample, in Germany, automatic stay does not ex-
tend to secured creditors, and these secured
creditors have incentives to opt for liquidation
bankruptcy (Kaiser, 1996). Therefore, many firms
do not have the opportunity to file for reorgani-
zation bankruptcy (even when this option is le-
gally allowed) because of the absence of auto-
matic stay of assets.
Proposition 4: An automatic stay of as-
sets specified by a bankruptcy law
will encourage entrepreneurship de-
velopment by curtailing the downside
risk of entrepreneurs.
The Fate of Managers
Managers make firm-specific investments
during their tenure with firms. This firm-specific
knowledge may especially be required when a
firm is in distress. The opportunity to stay with
the firm after filing for reorganization bank-
ruptcy provides incentives for managers to
make firm-specific investments. If managers are
going to be driven out when a firm files for
reorganization bankruptcy, not only will they be
reluctant to file bankruptcy but they also may
lack incentives to make firm-specific invest-
ments in the first place (Shleifer & Summers,
1988). If managers know ex ante that they will
not be replaced automatically in the case of
bankruptcy filing, the opportunity to stay with
the firm works as a “bonding device” (Gaston,
1997). Therefore, when a firm files for bank-
ruptcy, providing an opportunity for managers
to stay may provide those managers with firm-
specific investments a better chance to revive
the firm.
Firms can be heterogeneous, so firm-specific
investments by managers will increase variety
and value in a bundle of firms (Barney, 1991).
However, in a manager replacement system,
such as a trustee appointment system, appoint-
ing outsiders without firm-specific knowledge
for reorganization is not likely to lead to proper
reorganization (Alexander, 1999; Hashi, 1997;
Franks et al., 1996). For example, Chapter 11 in
the United States allows managers to retain
control of the firm and provides them the exclu-
sive right to propose reorganization plans. In
contrast, in Great Britain and Germany, control
rights are rendered to secured creditors (Franks
et al., 1996). Thus, the practice of allowing se-
cured creditors to take over (such as a trustee
appointment system) has been criticized for
leading to premature liquidation (Kaiser, 1996).
Proposition 5: At the time of filing for
bankruptcy, allowing incumbent
managers to stay on the job, rather
than having trustee-appointed outsid-
ers, will encourage entrepreneurship
development by curtailing the down-
side risk of entrepreneurs.
Some might argue that, for a small firm, the
firm’s debt is the owner’s personal debt and the
owner can just walk out and start a new busi-
ness. However, Surelemont and colleagues
(1999) show that, among the fifteen countries
they studied, only personal bankruptcy laws in
Finland and the United States do not go after the
entrepreneurs for the unpaid debt when a busi-
ness fails. When an entrepreneur has to person-
ally repay the debt for the past failure of busi-
ness, there is less incentive to take the risk of
starting up a new firm (Ziechmann, 1997). This is
why White (2001) argues that moving toward a
more debtor-friendly personal bankruptcy law
would discourage risk taking for entrepreneurs.
Overall, it is possible that an entrepreneur-
friendly bankruptcy law, informed by a real op-
tions perspective, may facilitate entrepreneur-
ship development at the societal level by
encouraging more risk taking through curtailing
downside risks for failed entrepreneurs and
their firms and through more enthusiastic cre-
ation of new firms (Efrat, 2002).
Proposition 6: When entrepreneurs are
not held personally liable for their
firms’ debts, there will be more entre-
preneurship development because
downside risk will be curtailed.
VENTURE CAPITAL AND STIGMA AS
MODERATORS
While the provisions of bankruptcy law repre-
sent important formal regulatory institutions
governing entrepreneurship, informal aspects of
the institutional environment, such as the avail-
264 January Academy of Management Review
ability of venture capital and the level of social
stigma concerning entrepreneurial failure, may
moderate the impact of bankrupt law on entre-
preneurship development. This is important, be-
cause the same entrepreneur-friendly bank-
ruptcy law may have different implications for
firms in different environments (Claessens,
Djankov, & Klapper, 2002).
The Role of Venture Capital
Relative to capital provided by banks or
raised in financial markets, venture capital is
often regarded as “informal capital.” It is well
known that venture capital is one of the impor-
tant engines for entrepreneurship development.
In risky industries there is more uncertainty and,
thus, a higher variance among firm survival and
performance (Landier, 2002). This combination of
high uncertainty and high variance entails sig-
nificant information asymmetries between lend-
ers—banks or venture capitalists—and borrow-
ers—firms (Le, Venkatesh, & Nguyen, 2006).
Under these circumstances, more hands-on
monitoring and advising is needed, a task ven-
ture capitalists perform better than banks. This
explains why venture capital funding is dispro-
portionately more prominent in industries
where information asymmetries are high—for
example, biotechnology—than in “routine” in-
dustries—for example, restaurants (Amit,
Brander, & Zott, 1998).
Close monitoring and valuable advice by ven-
ture capitalists would probably reduce the risk
of bankruptcy and the impact of an entrepre-
neur-friendly bankruptcy law on entrepreneur-
ship development. Since the risk of bankruptcy
is shared between entrepreneurs and venture
capitalists, entrepreneurs can take on more
risky projects than they would have been able to
otherwise. In addition, when a firm falls into
financial difficulty, venture capitalists may ini-
tiate restructuring before the need to file for
bankruptcy emerges. Therefore, in real options
terms, the existence of venture capital may par-
tially substitute for the role of a lenient bank-
ruptcy law on entrepreneurship development.
Proposition 7: In a society with a well-
developed venture capital infrastruc-
ture (characterized by the abundance
of venture capital and the availability
of strategic value added, such as mon-
itoring and advising provided by ven-
ture capitalists), there will be less im-
pact of an entrepreneur-friendly
bankruptcy law on entrepreneurship
development.
However, not all countries enjoy both the
abundance of venture capital and the deep in-
volvement of venture capitalists in start-up
firms (MacMillan, Kulow, & Khoylian, 1989). For
example, in Europe, venture capital only sup-
ports approximately 13 percent of start-ups,
whereas in the United States, the rate is more
than 30 percent.
4
Moreover, many venture capi-
talists are not deeply involved in the start-ups
they fund. For example, in France, venture cap-
italists do not spend as much time monitoring
and mentoring the ventures they finance as
their U.S. counterparts do (Sapienza, Manigart,
& Vermeir, 1996). In China, venture capitalists
often hesitate to provide direct advice to entre-
preneurs (Bruton & Ahlstrom, 2002). In Japan,
since many venture capital firms are subsidiar-
ies of banks and securities companies, they tend
to focus on relatively established firms (Yo-
shikawa, 2002). Therefore, in these countries
with relatively underdeveloped venture capital
infrastructure, an entrepreneur-friendly bank-
ruptcy law may be especially helpful in facili-
tating entrepreneurship development.
The Role of Stigma
In addition to reputational and financial
losses, entrepreneurs and managers incur huge
psychological costs—often referred to as stig-
ma—when filing bankruptcy (Shepherd, 2003).
Individuals from different countries are likely to
differ in their level of stigma associated with
bankruptcy. In a study of eight countries, high
uncertainty avoidance (Hofstede, 1980) was
found to be associated with a low level of busi-
ness ownership, presumably because of fear of
failure (McGrath, MacMillan, & Scheinberg,
1992). In a country with relatively low uncer-
tainty avoidance, such as the United States, peo-
4
Even in the United States, start-ups backed by substan-
tial venture capital are exceptional. For example, highly
successful entrepreneurs such as Bill Gates (Microsoft) and
Sam Walton (Wal-Mart) initially had to pursue small, uncer-
tain opportunities without much venture capital support
(Bhide, 2000).
2007 265 Lee, Peng, and Barney
ple are more likely to take risks and be more
tolerant of failures. No longer a dirty word,
“bankruptcy” probably does not carry the same
level of stigma as it did in the past in the United
States (Barr, 1992). For example, when American
West Airlines filed for Chapter 11 reorganization
bankruptcy, top managers spent a lot of time
boosting employee morale by explaining that
there was nothing to be ashamed of (!).
In contrast, in a high uncertainty avoidance
(risk-averse) culture, entrepreneurs filing for
bankruptcy may experience a higher level of
stigma, which is likely to deter would-be entre-
preneurs from pursuing their visions (Begley &
Tan, 2001; Sekiguchi, 2006). In Japan, not only
can business failure be considered a very
shameful deed (Tezuka, 1997) but filing bank-
ruptcy can even be considered a crime, and, as a
result, in extreme cases, some top managers
have reportedly committed suicide (Time, 1999).
In this regard, an entrepreneur-friendly bank-
ruptcy law may be less effective in a cultural
environment characterized by a high level of
stigma associated with bankruptcy. Countries
with a risk-averse culture, such as Japan, may
have difficulty enacting and implementing an
entrepreneur-friendly bankruptcy law, because
a law that is lenient on bankrupt individuals
and firms may violate informal but powerful
cultural norms. In other words, in real options
reasoning, high stigma in a society limits the
role of lenient bankruptcy law in increasing the
variance in a society.
Proposition 8: In a society with a high
level of stigma associated with bank-
ruptcy, there will be less impact of an
entrepreneur-friendly bankruptcy law
on entrepreneurship development.
THE COSTS OF AN ENTREPRENEUR-FRIENDLY
BANKRUPTCY LAW
Although we have focused on the benefits of
an entrepreneur-friendly bankruptcy law, it is
important to address the costs. The costs may be
manifested in at least three dimensions. First, to
the extent that a lenient bankrupt law encour-
ages risk taking, there is a possibility that en-
trepreneurs will take on a level of risk beyond
that which is socially optimal. However, many
individuals in a given society are risk averse. In
this context, the problem for society is not that
too many people are making risky investments
but that not enough people are making these
investments.
A second likely cost of an entrepreneur-
friendly bankruptcy law, especially the provi-
sion of allowing for the option of reorganization
bankruptcy (along the U.S. Chapter 11 model), is
the possibility of preserving a number of “per-
manently failing firms” (Meyer & Zucker, 1989).
These firms may be technically bankrupt, but
they do not exit competition. In an ever-chang-
ing uncertain environment, however, the
chances of survival of these kinds of firms are
not high in the long run. For example, while it is
possible for permanently failing firms to survive
in a highly regulated environment, it is not as
common as in the past, because when deregu-
lation takes place, the wind of change can be
fierce (Meyer & Peng, 2005; Peng, 2003, 2005, 2006;
Silverman, Nickerson, & Freeman, 1997; Wright
et al., 2005). In other words, we argue that leav-
ing options open (providing options to file for
reorganization bankruptcy) should be the focus
of the bankruptcy law. At the same time, we
argue that it is important to make it easier to file
for a liquidation bankruptcy. The reason is that
since making reorganization bankruptcy easier
increases the level of competition in a society,
market discipline would take care of the termi-
nation of firms with little future through liquida-
tion bankruptcy. However, when there is high
cost in exit, those firms that should exit (liqui-
date) might not exit. In this sense, it is also
important to make it easier to exit through liq-
uidation bankruptcy.
Finally, there may be important social costs
associated with opportunistic entrepreneurs
who take advantage of an entrepreneur-friendly
bankruptcy law. For sure, if there are too many
such entrepreneurs, the social costs may out-
weigh the social gains. This can happen when
there is nothing for entrepreneurs to lose when
they file for bankruptcy. However, this condition
may not hold when we consider the negative
impact on an individual’s reputation of inten-
tionally starting a business to take advantage of
a lenient bankruptcy law (Gilson, 1989, 1990).
Many entrepreneurs cannot start a business
only with outside debt, without investing their
own financial resources. In addition to losing
opportunistic entrepreneurs’ own financial in-
vestments, future access to credit would become
much harder (Berkowitz & White, 2004).
266 January Academy of Management Review
Overall, an entrepreneur-friendly bankruptcy
lawis not a painless bankruptcy law. It is simply
less painful for bankrupt entrepreneurs, who
will still have to endure a significant amount of
reputational and financial losses, as well as a
high degree of stigma. Given the choices of (1)
being lenient on a small number of opportunis-
tic entrepreneurs and (2) being harsh on a large
number of honest but failed entrepreneurs, it
seems reasonable that the social benefits of an
entrepreneur-friendly bankruptcy law outweigh
its costs.
DISCUSSION
Contributions
In our view, three contributions distinguish
this article. First, we extend real options think-
ing (McGrath, 1999) froma firmlevel to a societal
level by exploring how an entrepreneur-friendly
bankruptcy law can promote entrepreneurship
development. From a societal perspective,
thinking of options as a bundle of firms, instead
of single firms, is important. A bankruptcy law
that curtails the downside losses of entrepre-
neurial failures is likely to facilitate upside
gains, enhance the variance and value of the
bundle of productive assets within an economy,
and lead to stronger and more sustained eco-
nomic growth.
Second, while bankruptcy traditionally has of-
ten been viewed negatively, we advocate that
an entrepreneur-friendly bankruptcy law, in-
formed by a real options logic, may encourage
entrepreneurship development. Similar to the
saying “No pain, no gain,” we believe that an
economy unwilling to shoulder the costs of cer-
tain entrepreneurial failures is not likely to reap
the benefits of a vibrant entrepreneurial sector
and the growth it may bring. Consequently, we
advocate a bankruptcy law designed to em-
brace the “pain” of failure of firms and, hope-
fully, “gain” from more sustained entrepreneur-
ship development.
Finally, this article opens a new avenue of
research on how institutional frameworks such
as bankruptcy law affect strategic choices
(Meyer & Peng, 2005; Peng, 2003, 2005; Peng et al.,
2005; Wright et al., 2005). This can potentially
lead to an institution-based view of strategy
(Peng, 2006). While bankruptcy law has been
studied rather widely in finance and economics,
it has not been of keen interest among manage-
ment and strategy scholars (Daily & Dalton,
1994). Past research on bankruptcy in finance
and economics generally has focused on the
efficiency of bankruptcy law at the firm level
(e.g., Bebchuk, 2000; Gilson, 1989; White, 1994).
We take a different approach by examining the
role of bankruptcy law in terms of facilitating
entrepreneurship development at the societal
level. In particular, increasing variance via an
entrepreneur-friendly bankruptcy law is a novel
idea that has rarely been visited in past bank-
ruptcy research, as well as in entrepreneurship
research.
Future Research and Policy Implications
Of course, an entrepreneur-friendly bank-
ruptcy law is but one of many mechanisms that
can facilitate entrepreneurship development at
a societal level. Other mechanisms, such as
patent protection, bank financing, and tax re-
duction, all play a complementary role. Given
that these areas have been studied at length, we
have chosen to focus on the relatively uncharted
waters (in management research at least) of
bankruptcy law. This admittedly is a limitation
of this article. It is true that many entrepreneurs
rush to start up new firms with little planning
and that many of them probably do not check
out the nuances of the bankruptcy law before
taking the plunge.
However, what we do not know is how many
would-be entrepreneurs are deterred by the
daunting and highly likely possibility of ending
up in bankruptcy and thus decide not to pursue
their entrepreneurial visions.
5
This could stem
from exposure to information on the high per-
centages of start-up failures, to media reports of
the stigma of bankrupt individuals, and/or to
word-of-mouth regarding the difficulty experi-
enced by friends and family members who file
for bankruptcy. Given that starting up new firms
is inherently a high-risk endeavor and that an
unknown but presumably large number of en-
trepreneurial ideas are given up, it stands to
reason that anything that can lower these risks
would help promote entrepreneurship develop-
5
Fan and White (2003) found that U.S. states with a higher
level of debt exemption are associated with a higher level of
entrepreneurship development.
2007 267 Lee, Peng, and Barney
ment. Of course, an entrepreneur-friendly bank-
ruptcy law is not a panacea and does not work
in a vacuum. In future work, we envision that
research on bankruptcy law can be integrated
with some of the existing topics above to create
a more coherent understanding in terms of how
these components come together as a package
to lower both entry and exit barriers to entrepre-
neurship development.
We have examined the stigma of failure at the
societal level. However, even within a society,
stigma of failure is not uniform across indus-
tries. In high-tech industries characterized by
high uncertainty and high variance, a lower
level of stigma of failure may exist—compared
to relatively low-tech, low-risk industries
(Landier, 2002). Anecdotal evidence from Silicon
Valley suggests a motto of “fail fast, fail cheap,
move on” (Saxenian, 1994). More systematic
cross-industry research in this area appears to
be promising. Further, while we have focused on
the impact of bankruptcy law on smaller firms,
how large corporate bankruptcies, with huge fi-
nancial impacts on society, are affected by a
more liberal bankruptcy law remains to be seen
in future research.
For policy makers, it seems that enacting and
implementing an entrepreneur-friendly bank-
ruptcy may, paradoxically, increase the number
of corporate bankruptcies. For example, in the
United States, under the old, pre-1979 bank-
ruptcy law, firms were not legally permitted to
file for reorganization bankruptcy, even when
they needed bankruptcy relief (LoPucki, 1992).
After the passage of the Bankruptcy Reform Act
in 1979, the number of firms filing bankruptcy
doubled, and many took advantage of the avail-
ability of Chapter 11 reorganization bankruptcy
(Weiss, 1990; Wruck, 1990). The real options per-
spective developed here suggests that such an
increase in the number of corporate bankrupt-
cies may be beneficial for the option value of the
bundle of assets within one country. Likewise, in
Thailand, legal reforms of the bankruptcy law to
make bankruptcy filing easier after the 1997 eco-
nomic crisis actually increased the country’s to-
tal equity values by 25 percent (Foley, 2000;
White, 2004). Overall, while curtailing downside
losses may inevitably cause more failing entre-
preneurs and managers to file bankruptcy for
their firms, the risk of not taking such a risk, in
the long run, may be higher for any society as-
piring to have a high level of entrepreneurship
development.
CONCLUSIONS
While it has long been known that the rules of
the game that specify the relative payoffs play a
key role in determining the scale and scope of
entrepreneurial activities within a society, we
have just set out on the long road to achieving
an understanding of how an entrepreneur-
friendly bankruptcy law, informed by a real op-
tions perspective, can stimulate more entrepre-
neurship development. Given the pervasiveness
of entrepreneurial failures and bankruptcies in
the economic landscape around the globe, it
seems imperative that a higher portion of the
entrepreneurship research agenda on wealth
creation be directed toward this important but
understudied area.
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2007 271 Lee, Peng, and Barney
Seung-Hyun Lee ([email protected]) is an assistant professor of international
business at the University of Texas at Dallas. He received his Ph.D. from The Ohio
State University. His research interests are international political strategies and
emerging economies.
Mike W. Peng ([email protected]) is the Provost’s Distinguished Professor of
Global Strategy at the University of Texas at Dallas and editor-in-chief of the Asia
Pacific Journal of Management. He received his Ph.D. from the University of Wash-
ington. His research interests are global strategy and emerging economies.
Jay B. Barney ([email protected]) is the Bank One Chair of Excellence in Corporate
Strategy at the Fisher College of Business, The Ohio State University. He received his
Ph.D. from Yale University. His research interests are corporate strategy and policy.
272 January Academy of Management Review

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