Entrepreneurship and the Barrier to Exit: 

How Does an Entrepreneur-Friendly Bankruptcy Law Affect 

Entrepreneurship Development at a Societal Level?

by Seung-Hyun Lee, Yasuhiro Yamakawa, and Mike W. Peng of the University of Texas at Dallas under 

contract no. SBAHQ-06-M-0536 to the Babson College Entrepreneurship Research Conference for the Award. 

2008. [18] pages.

This report was developed under a contract with the Small Business Administration, Office of Advocacy, and contains information

and analysis that was reviewed and edited by officials of the Office of Advocacy. However, the final conclusions of the report do not 

necessarily reflect the views of the Office of Advocacy.

Introduction

This paper was originally presented in Madrid, 

Spain, at the Babson College Entrepreneurship 

Research Conference (BCERC) in June 2007. It 

was awarded the Office of Advocacy Best Paper 

Award at the 2008 BCERC meetings in Chapel 

Hill, North Carolina. 

Seung-Hyun Lee is an Assistant Professor 

of Organizations, Strategy & International 

Management in the School of Management 

at the University of Texas at Dallas, Yasuhiro 

Yamakawa is a Ph.D. Student in the School of 

Management at the University of Texas at Dallas, 

and Mike W. Peng is Provost’s Distinguished 

Professor of Global Strategy in the School of 

Management at the University of Texas at Dallas.

Purpose

How a society’s formal institutions, such as bankruptcy laws, govern bankrupt entrepreneurs and 

firms is an important component of the institutional framework within which entrepreneurs and 

firms operate. The legal procedures associated 

with bankruptcy vary significantly across countries. Some countries provide only limited protection for entrepreneurs and managers of bankrupt 

firms, while others have a more entrepreneurfriendly bankruptcy law. Overall, whether the 

institutional framework encourages or discourages 

entrepreneurship may determine a society’s longrun economic performance.

The authors examine the relationship between 

bankruptcy law and the value-creating activities in 

a society associated with risk-taking behaviors by 

entrepreneurial firms. They argue that an entrepreneur-friendly bankruptcy law may increase the 

number of corporate bankruptcies, which may be 

indicative of a vibrant entrepreneurial economy.

This paper tests hypotheses relating to seven 

key aspects of bankruptcy laws using a longitudinal database covering 35 countries and spanning 

10 years. 

Overall Findings

The authors find that a lenient, entrepreneurfriendly bankruptcy law encourages entrepreneurs 

to take risks and thus lets entrepreneurship prosper. This risk-taking can generate variety in the 

economy by increasing the number of firms with 

high growth potential, which may lead to more 

entrepreneurship and economic development—in 

short, failure may be good for the economy. The 

study pushes for a more informed understanding 

of how formal institutions governing bankruptcy 

matter for entrepreneurial behavior and outcomes. 

It emphasizes that a society that is not willing 

to absorb the “pain” of having a large number 

of entrepreneurial failures, via an entrepreneurfriendly bankruptcy law, is not likely to reap the 

“gain” of vibrant entrepreneurship development 

and economic growth. 

June 2008 No. 326
Highlights

The study analyzes seven components of an entrepreneur-friendly bankruptcy law and finds:

• The availability of reorganization procedures 

as a choice for bankrupt firms encourages bankruptcy filings.

• Less time and less cost associated with a 

bankruptcy proceeding encourages entrepreneurs 

to file for bankruptcy and is consistent with higher filing rates in a country.

• The more resources entrepreneurs recover 

from bankruptcy—which would mean a fresher 

start—the higher the filing rate in a country.

• An automatic stay on assets is likely to 

encourage entrepreneurs to file bankruptcy.

• The protection of creditors at the time of 

bankruptcy leads to a higher rate of bankruptcy 

filing.

• One result appears contradictory—that is, 

allowing incumbent managers to stay on the job 

does not lead to a higher rate of bankruptcy. 

Rather, management turnover leads to an increase 

in filing. More capable managers may have moved 

elsewhere.

Note

This paper was prepared for presentation at 

the Babson College Entrepreneurship Research 

Conference. The report references “space limitations” and “suppressed” control variables in the 

tables. The authors needed to comply with strict 

guidelines for submission to the BCERC, including a page limitation. The Office of Advocacy 

is releasing as a working paper the BCERC version of the paper, which adheres to these guidelines. This research was supported, in part, by a 

National Science Foundation (NSF) CAREER 

grant (SES 0552089) to Mike W. Peng. The views 

expressed are those of the authors and not necessarily those of the NSF or the SBA Office of 

Advocacy.

Scope and Methodology

The authors collected data for 35 countries during the 10 years 1990-1999 (inclusive). Data were 

drawn from commercial bankruptcy filings, legal 

rules, and other data from the World Bank, the 

World Health Organization (WHO), and the 

International Monetary Fund (IMF).

Analysis of reorganization procedures is based 

on bankruptcy data from government and private 

sources. Data on closing time, closing cost, and 

fresh start (measured by rate of recovery from 

a closing) were obtained from the World Bank. 

Data on legal rules covering protection of corporate shareholders and creditors, their origin, and 

the quality of their enforcement and on the regulation of entry are gathered from past studies.

The authors test hypotheses that predict how 

various components of bankruptcy law can curtail the downside risk of entrepreneurs and help 

encourage risk-taking behavior such as filing for 

bankruptcy. A log-linear model is used to model 

the changes in bankruptcy filings. The dependent 

variable is the bankruptcy rate—the ratio of the 

number of bankruptcies to the total number of 

firms—and is allowed to take both positive and 

negative values rather than being constrained to 

be positive. The model controls for four major factors: (1) the previous year’s number of bankruptcies for each country, (2) regional effects, (3) possible time effects across all countries, and (4) one 

social dimension of bankruptcy law that reflects 

the level of social stigma concerning failure and is 

measured by the suicide rate.

This report was peer-reviewed consistent with 

Advocacy’s data quality guidelines. More information on this process can be obtained by contacting the director of economic research by email at 

advocacy@sba.gov or by phone at (202) 205-6533.

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