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Financial constraints have been cited as one of the most important impediments to entrepreneurship, but why do people encounter such constraints?
A study of Danish entrepreneurs, some of whom became entrepreneurs after receiving a windfall inheritance, suggests that financial constraints in themselves may not be the central problem. Instead, the low quality of entrepreneurs could be a deciding factor.
Comparing the survival rates, entrepreneurial profits and total personal income of “constrained” entrepreneurs (who became self-employed after receiving windfall wealth) and “unconstrained” entrepreneurs (who started a business without such a windfall), the study found that the latter group survived longer and had higher profits and income up to five years after establishing their businesses.
This had implications for policy makers, said the authors, Steffen Andersen and Kasper Meisner Nielsen.
“Although other studies demonstrate that low-wealth households are excluded from capital markets, this observation does not imply policy makers should make loans easier to come by. Subsidizing credit may decrease efficiency because it offsets the disciplining role of capital markets. The barrier to firm formation might therefore be low entrepreneurial quality rather than access to financing,” they said.
The authors were able to demonstrate this through a unique dataset from Denmark that enabled them to identify windfall wealth from unexpected inheritance and relate it to entrepreneurial activity.
Focusing on the period 1995-2001, they identified 304 constrained entrepreneurs and matched them by age, gender, education level and pre-entrepreneurship income and wealth with a similar number of unconstrained entrepreneurs.
Both groups started a business in the same period but after one year, only 64.1 per cent of constrained entrepreneurs remained in business against 75 per cent of unconstrained entrepreneurs. After five years the survival rate was 41.9 per cent for constrained versus 50 per cent for unconstrained entrepreneurs.
Entrepreneurial profit was on average 22 to 39 per cent lower for constrained entrepreneurs over the same five-year period, and total personal income was 5 to 20 per cent lower.
The authors also tested whether wealth alone could explain the findings by comparing the constrained group with unconstrained entrepreneurs who inherited shortly after forming a business. The results held up: these unconstrained entrepreneurs still survived longer and performed better, indicating wealth was not a confounding factor. In fact, they saw their profits rise by about 10 per cent after inheritance.
“Our study challenges premises behind policies that facilitate broad access to financing, which is that frictions in the capital markets preclude entrepreneurs with good ideas from starting a business. Our results question the welfare gains from promoting entrepreneurship among constrained individuals,” the authors said.
However, they continued, “these results do not imply all individuals with worthy projects will obtain financing. Frictions in the capital markets might prevent some entrepreneurs with good projects from starting a new business, and lenders might find it optimal to ration their access to capital. Nevertheless, the rationale for initiatives to promote wider entrepreneurship should focus on eliminating the cause of frictions or discrimination rather than on providing broad access to financing.”
This article is contributed by HKUST Business School.