Personal Experience: A Most Vicious and Limited Circle!?

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Dis cus si on Paper No. 07-046

Personal Experience:
A Most Vicious and Limited Circle!?
On the Role of
Entrepreneurial Experience for Firm Survival

Georg Metzger

Dis cus si on Paper No. 07-046

Personal Experience:
A Most Vicious and Limited Circle!?
On the Role of
Entrepreneurial Experience for Firm Survival

Georg Metzger

Download this ZEW Discussion Paper from our ftp server:
ftp://ftp.zew.de/pub/zew-docs/dp/dp07046.pdf

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der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.

Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other
eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly
respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.

Non-technical summary

In order to give an answer to the question of whether personal entrepreneurial
experience promotes firm survival, or is rather, to quote Oscar Wilde, “a most
vicious and limited circle”, this paper provides a close examination of how firm
survival depends on experience. It analyzes how successful firms are in which at
least one ex-entrepreneur who abandoned a business previously (so called ‘re-
starters’) participates, i.e. how they differ in their risk of failure compared to
other firms. In this regard, it is of particular interest whether entrepreneurs learn
their lesson from their previous business failure. There are several theoretical
arguments and mechanisms which come into the analysis of this issue. A posi-
tive impact of entrepreneurial experience on firm survival can be derived from
the human capital theory. This expected effect is therefore expressed in the first
hypothesis. The idea of learning mechanisms induced by negative experience
would lead us to expect failure experience to affect firm survival positively, too.
This expectation is set down in the second hypothesis.

For the survival analysis, this study makes use of the ZEW Foundation Panel.
The panel is the result of a co-operation between the Centre for European Eco-
nomic Research (ZEW) and Creditreform, which is the largest German credit
rating agency. The size of Creditreform means that their data on enterprises in
Germany is the most comprehensive available. Creditreform has provided the
data in semi-annual waves since 1989. The ZEW Foundation Panel contains in-
formation about three million start-ups which occurred between 1990 and 2005.
The unit of registration is the company itself rather than any subsidiaries, i.e. this
investigation is based on original foundation events and ignores affiliated foun-
dations.

The analysis herein addresses the question of whether personal entrepreneu-
rial experience promotes firm survival respectively lowers a firm’s risk of clo-
sure. The question can even be understood as: does entrepreneurial experience
affect the probability of business failure? Not every firm closure can be consid-
ered as a business failure. Thus, failures have been disentangled from the total
number of firm closures and analyzed separately. Two types of failure types can
be identified: bankruptcy and the voluntary closure of a firm in financial distress.
The results of the analyses suggest that experiences indicating success have no
great effects on the risk of failing with a restart. Contrarily, negative experience,
i.e. previous entrepreneurial failure, raises the risk of failing again. This means
that the hypotheses – that experience initiates learning and thus more success –
must be rejected. In particular, the assumption that experience of failure induces
higher-level learning is dismissed as the opposite is found to be true: failure ex-
perience increases the risk of further failure.

Personal Experience: A Most
Vicious and Limited Circle!?
On the Role of Entrepreneurial
Experience for Firm Survival

Center for European Economic Research (ZEW), Mannheim,
P.O. Box 103443 D-68034 Mannheim, metzger@zew.de

Georg Metzger

September 2007

Abstract: The analysis in this paper gives attention to
effects on firm survival which come from entrepreneu-
rial experience. It is likely that different kinds of experi-
ence result in different firm developments and therefore
in different types of firm exit. Particular emphasis is
placed upon the effects of failure experience. The results
provide evidence that both the kind of experience and
the type of exit matter. Negative experience, namely the
experience of failure, is found to heighten the risk of
failing again. This finding indicates that business failures
are largely not exceptions, but rather a sign of the entre-
preneurs’ lack of ability.

Keywords: Entrepreneurial Experience; Business Failure; Firm Survival.
JEL Classification: G33; L25; L26; M13.

Acknowledgements
The author would like to thank Dirk Czarnitzki, Michael Fritsch and Elisabeth Müller for their
valuable remarks. I would also like to thank Francesca Lotti for her helpful comments at the
ESSID Summer School 2006. The paper was partly written during a research stay at the Katho-
lieke Universiteit Leuven, Belgium.

PERSONAL EXPERIENCE: A MOST VICIOUS AND LIMITED CIRCLE!?

1

Introduction

Firm formation is seen as a strong force behind economic growth (Kirchhoff
1994; Reynolds 1994, 1999; Wennekers and Thurik 1999). Early analyses for
Germany were unable to validate this view (Audretsch and Fritsch 1994; Fritsch
1996) but during the 1990’s it became more and more evident (Audretsch and
Fritsch 2003). Firm closures are the counterpart of firm formation and are no less
relevant. Production factors tied up in existing firms need to be released before
they can be reallocated. However, this is the macroeconomic view. In microeco-
nomics firm survival is often used as a measure of success and firm closure taken
to be synonymous with failure.

The survival of a firm is influenced by several factors. Some, like economic
conditions within a region or industry, affect all firms similarly (Audretsch 1991;
Brüderl et al. 1992; Stearns et al. 1995). Other factors are firm-specific, like the
firm’s age or its size at the time of foundation (Audretsch and Mahmood 1995;
Brüderl et al. 1992; Mata 1995). Some of the impacts are generally accepted and
are stylized as ‘liability of smallness’, ‘liability of newness’, or ‘liability of ado-
lescence’ (Brüderl and Schüßler 1990; Mahmood 2000; Stinchcombe 1965). But
even if such relationships are certain, a firm’s development actually depends on
the decisions of its managers and, thus, on their specific skills. Hence, the entre-
preneur’s human capital should be a highly relevant success factor.

Human capital is built up by learning. Possible ways of learning considered
here are schooling, vocational education, or professional experience (Becker
1985; Mincer 1974). Experience is a particularly important source of learning as
learning means to solve problems and so necessarily involves activity (Arrow
1962). Entrepreneurial knowledge and skills are thus best acquired by experienc-
ing entrepreneurship, i.e. from being an entrepreneur. A typical means of meas-
uring entrepreneurial experience is to track previous self-employment episodes
or previous firm ownership. However, this approach only captures a very general
kind of entrepreneurial experience as the reality of entrepreneurship is not that
simple. Such experience is heterogeneous: at the very least it can be divided di-
chotomously into ‘good’ experience and ‘bad’ experience. In this simple binary
classification, good experience is likely to be associated with success and bad
experience with failure. Nevertheless, a business failure might be useful: making
mistakes is supposed to be the predominant source of learning for small business
entrepreneurs (Gibb 1997). It is even suggested that bad experience initiates a
superior kind of learning (Chialvo and Bak 1999; Cope 2005). Such arguments
are often voiced in discussions about previously failed entrepreneurs. Yet they
are rarely, if ever, tested against empirical data.

The analysis herein addresses the question of whether personal entrepreneu-
rial experience promotes firm survival or, to be more precise, lowers a firm’s risk
of closure. The question can even be understood as: does entrepreneurial experi-

2

PERSONAL EXPERIENCE: A MOST VICIOUS AND LIMITED CIRCLE!?

ence affect the probability of business failure? Not every firm closure can be
considered as a business failure. Thus, failures have been disentangled from the
total number of firm closures and analyzed separately. Two types of failure types
can be identified: bankruptcy and the voluntary closure of a firm in financial
distress. The results of the analyses suggest that experiences indicating success
lower the risk of failing with a restart. Contrarily, negative experience, i.e. previ-
ous entrepreneurial failure, raises the risk of failing again. This means that the
hypotheses – that experience initiates learning and thus more success – must be
rejected. In particular, the assumption that experience of failure induces higher
level learning is dismissed as the opposite is found to be true: failure experience
increases the risk of further failure.

Theoretical perspectives

The survival analysis herein focuses on effects arising from entrepreneurial
experience – particularly effects arising from failure experience. It is therefore
necessary to disentangle failure experience from each entrepreneur’s body of
experience. This is not easy to do on the basis of the observable facts. What is
observable is if and how an entrepreneur previously abandoned a firm. From this
one can distinguish four cases: (1) the entrepreneur has not previously partici-
pated in a firm, (2) the entrepreneur is still a participant in a firm founded at an
earlier date, (3) the entrepreneur has ceased to participate a firm which is cur-
rently still a going concern, or (4) a previous venture on the part of the entrepre-
neur was closed down. Based on these states a previous business failure can only
be assumed in the latter case, i.e. if a venture was actually closed. But even in the
case of closure it is difficult to detect a business failure. In reality, “the definition
of failure used has, to a large extent, depended on the nature of the data avail-
able” (Everett and Watson 1998, p. 374).

One way to define failure is to use an objective measure, such as bankruptcy.
Bankruptcy is a technical term meaning financially difficult situations like an
inability to pay creditors or excessive debts, and is thus attributable to objective
and concrete factors. Personal bankruptcies, i.e. bankruptcies for individuals
rather than for business entities, are relevant when the entrepreneurs are sole
proprietors or entrepreneurs in liberal professions. But legally forced involuntary
closures due to bankruptcy are not the only type of closure. There are also ‘vol-
untary’ firm closures. The reasons for voluntary closures are not obvious and can
be diverse. For example, an entrepreneur might choose to close his or her busi-
ness in order to avoid bankruptcy, to go back to employment, to go into retire-
ment, to make a clean break and open a different business, or due to other sub-
jective motives.

Owing to the wide range of reasons for closure, additional information has to
be used to disentangle business failures from the set of voluntary firm closures.
Smith (1987) points out that signals from the payment behavior of buyers can

PERSONAL EXPERIENCE: A MOST VICIOUS AND LIMITED CIRCLE!?

3

normally be used by sellers to identify financially strong firms, and that “the
screening process is effective in sorting if it is sufficiently more costly for high
default-risk buyers to signal financial health than low default-risk buyers” (Smith
1987, p. 868). Therefore, information about the firms’ payment behavior is
brought into the analysis. This can be used to distinguish between firms which
keep to the payment terms or exceed them only occasionally, and other firms.
This approach allows the detection of latent failures among the voluntary clo-
sures by looking for deteriorated payment behavior, which firms are likely to
exhibit before closures that are officially voluntarily but actually economically
forced, for example to avoid bankruptcy. Due to the lack of additional data,
bankruptcy and the voluntary closure of a distressed firm are the only definitions
of failure which can be considered. Of course, other Entrepreneurs, for example
those who close a firm because they don’t achieve their targets, might also be
considered as having failed.

As summarized in Table 1, there are four experience indicators introduced in
the survival analysis, which classify the entrepreneurs by their most recent pre-
vious venture: (1) restarters who left a firm by the way of sale of shareholdings,
(2) restarters who voluntarily closed a financially sound firm, (3) those who vol-
untarily closed a financially distressed firm and (4) restarters who went bankrupt.
The first two restart types can be considered as having something like entrepre-
neurial success experience, while the latter two restart types indicate failure ex-
perience.

Table 1: Experience measures

Exit experience due to…

Definition

Indicator stands for…

Sale of shareholdings

Entrepreneurs abandoned a previous business by the sale
of their shareholdings.

Success

Closure/liquidation of finan-
cially sound firm

Entrepreneurs abandoned a previous business by the
closure/liquidation of the firm. The firm is assessed to
have been in a financially sound situation.

Closure/liquidation of finan-
cially distressed firm

Entrepreneurs abandoned a previous business by the
closure/liquidation of the firm. The firm is assessed to
have been in a financially distressed situation.

Bankruptcy

Entrepreneurs abandoned a previous business due to
bankruptcy of the firm.

Success

Failure

Failure

Previously failed restarters can be denoted as ‘determined entrepreneurs’ be-
cause they closed their firms for financial reasons but are not discouraged by this
experience (Stokes and Blackburn 2001). There is another type of experienced
entrepreneurs: so called portfolio entrepreneurs. They found or participate in a
new business while they are still involved in an existing firm. Hence, portfolio
entrepreneurs do not fit the definition of restarters because they lack the funda-
mental requirement of closure. They are therefore not taken into consideration.
Additionally, they are different from restarters or serial entrepreneurs in many
ways. They differ in their whole attitude to entrepreneurship, i.e. the reasons

4

PERSONAL EXPERIENCE: A MOST VICIOUS AND LIMITED CIRCLE!?

behind their ambition to start up or grow a business (Westhead and Wright
1998). Including portfolio entrepreneurs in the present consideration would mean
moving too far from the central focus of this paper

Derivation of hypotheses

As discussed above, the survival of a firm depends on many factors. Never-
theless, the capability of the entrepreneur to make the right decisions should play
an important role for a firm’s success. An individual’s human capital is a meas-
ure for this capability: the higher her/his human capital the more likely an entre-
preneur is to do a better job. This effect is suggested by the human capital theory.
The theory hypothesizes that investment in skills through formal educational
attainment, on-the-job training or professional experience increases the produc-
tivity of workers (Becker 1985; Mincer 1974). Yet the theory need not be limited
to employees. It is similarly appropriate when applied to entrepreneurs, to ex-
plain differences in the success of businesses. Experience of self-employment
enhances entrepreneurship-specific human capital and increases the individual’s
ability to manage a firm well. Only this indirect effect of entrepreneurial experi-
ence on firm survival can be derived based on the original human capital theory.

Cressy (1996) developed a more purposeful model based on the model of en-
trepreneurial choice (Evans and Jovanovic 1989). The model of entrepreneurial
choice regards the decision to enter self-employment as dependent on expected
future returns, which are related to the decision-maker’s human capital. In
Cressy’s variety, human capital has a direct effect as it is used in modeling the
utility of both self-employment and wage employment. Following his model,
experience increases the probability of making the most of self-employment,
through a process of entrepreneurial learning. As a consequence, it improves
survival. Indeed, ex-entrepreneurs who embark on a new entrepreneurial venture
should have learned from their experience otherwise they wouldn’t return (Stam
et al. 2006). Learning effects are also suggested by Chialvo and Bak (1999) who
simply conclude: “If an adaptive system [novice entrepreneurs in this context] is
placed in a new environment, or otherwise subjected to learn something new, the
likelihood of making mistakes is generally larger than the chance to be initially
right” (Chialvo and Bak 1999, p. 1139).

Enhanced human capital based on specific experience also lowers the nega-
tive effects of what Van den Steen (2004) calls ‘choice-driven over-optimism’.
This refers to the basic range of alternatives an individual has. From a set of al-
ternatives, they choose the one that promises the most success. The actual choice
made is, nevertheless, the one about which they are also most optimistic – fre-
quently over-optimistic. This drives the probability of failure. The choice bias
“tends to disappear with sufficient experience with the particular choice prob-
lem” (Van den Steen 2004, p.2). This enables experienced entrepreneurs to as-