An economic perspective on trends in start-ups, and -downs

The federal government’s Innovation Statement of 2015 contained some simplistic aims for the promotion of entrepreneurial activity from proposed changes to our insolvency laws. A recent report from an economic perspective provides the level of analysis that is needed to assess the need for and the impact of those laws.

The changes to our insolvency laws following the government’s Innovation Statement of 2015 have simplistic aims. Simplistic because that is at the level that governments sell their ideas, but also because the law itself will only be one measure by which the aim – to promote entrepreneurial endeavour by reducing the legal consequences of entrepreneurial risk – might be achieved.

Our new insolvency safe harbour laws, enacted by new section 588GA in the Corporations Act, have been heralded as providing a new legal environment in which entrepreneurial and other business financial difficulties, and failure, can be managed, without the prescriptive threat of director liability for insolvent trading, often a concomitant of attempts at business rescue.

Law reform in this area must necessarily have regard to the economics involved, and without that regard, it may well fail. For various reasons, the level of economic input into these reforms would have been limited.

Entrepreneurship Dynamics in Australia: Lessons from Micro-data

What is required is the level of analysis contained in a recent research report from a senior economist in the Office of the Chief Economist, Dr Sasan Bakhtiari, Entrepreneurship Dynamics in Australia: Lessons from Micro-data. From an insolvency lawyer’s perspective, the report offers a very useful economic perspective on innovation, business risk and how it works, belying the simple approach taken by the law.

Sasan Bakhtiari

The report has three main messages:

1. The rate of entrepreneurship entry is falling

2. Those entrepreneurs who are entering are facing more risks

3. Despite this, the job creation prowess of the entrepreneurs who enter is steady and has even been increasing.

As Dr Bakhtiari advises me, the study was done as a counter-point to similar studies conducted in the US where the rate of entrepreneurism is falling and entrepreneurs are, in contrast to Australia, not creating jobs: see this story from the Washington Post. 

The report

Paraphrasing from the report, Dr Bakhtiari explores the dynamics of entrepreneurship in Australia and their evolution over the period 2002-2015. His finding is that

“the Australian entrepreneurial landscape has become less dynamic and more hazardous”

over that period.

Relatively fewer entrepreneurs are entering the market, and those that do enter are more likely to exit than their counterparts that entered in earlier years.

In particular, he explains,

“there is a seemingly permanent increase in exit probability starting from the cohort of 2005 entries, followed by a temporary spike after the Global Financial Crisis (GFC). Despite fewer firms entering, the share of young firms from job creation has been steadily high”.

He discusses the impact of the GFC but says that

“the more urgent issue facing the Australian economy is that even after factoring out the impact of the GFC, the entry rate and survival of entrepreneurs is still declining at a considerable pace. Given that these firms are the very reason behind jobs growth in Australia, there is much to worry about the future of job market and unemployment”.

As Dr Bakhtiari explains,

“there is space for policy consideration to assist entrepreneurs, once the reason behind the declining trend is understood”.

Extracts

Some extracts from his report (with some of my paraphrasing) are these.

A deterioration in entrepreneurial dynamics

“The changes in entrepreneurial dynamics over time, however, suggest deterioration. Fewer entrepreneurs are entering, and those that enter are increasingly likely to fail and exit. The trend is shared among almost all industries and sectors. The important exception is the mining sector, where survival chances for young firms actually improves.

Net job creation in Australia is also suffering as a result of this downturn, entrepreneurs being the engine of jobs growth.

Granting all this, there is ground for optimism as the share of entrepreneurs from job creation has not subsided. Despite their lower numbers, entrepreneurs that enter are still as enthusiastic to create jobs as they used to be.

“As to a few possible reasons behind the observed trends. On top of my list stands the impact of the resources boom, with the mining sector as the only industry to show immunity to the rising risks. I also discuss the merits of considering increasing lending costs, globalisation, changing demographics, and increasingly centralised industries as the other potential causes”.

“… that the rate of entrepreneurs entering in Australia looks rather flat before 2005 but started declining from 2005. In 2005, Australia has an entry rate of 15 per cent, a rate that on its face is comparable to those from the other countries showcased.

By 2015, the entry rate in Australia sinks to about nine per cent, a drop of almost 40 per cent. The entry rate has also been falling in the US over the same period. However, the fall in Australia is much steeper by comparison. In contrast to both the US and Australia, the entry rate in the UK has stayed strong and only had a temporary slump during the GFC.

The entry rate in Canada is by comparison stable and only shows a slight drop over the period, though it has gone through a longer-term decline since 1983 … . In New Zealand, one observes a trend similar to that of Australia. However, the drop practically comes to an end in 2010, while the entry rate in Australia keeps falling past this year. New Zealand experiences an upturn in the entry rate after 2012”.

Phoenix companies

As to the law’s concern with phoenix companies (paraphrased, reference omitted),

“… new firms can appear for reasons other than entrepreneurship. For instance, establishment of phoenix companies, a change of ownership or split in the ownership of a firm can spawn spurious entries. BLADE[1] does not provide any longitudinal link between these ‘new’ firms and their past existing identity. The suspicious cases are those new firms with more than a hundred or even thousands of employees in their first year, albeit the possibility that these firms might be super-apt entrepreneurs. On the positive side, the number of new firms with FTEs larger than 100 in their first year constitutes only about 0.05 per cent of all entries. Their relatively tiny number means that their classification either way will not have any statistical impact on most of the findings”.

Why firms fail

“For entrepreneurs to have an impact on the economy, the mere entry of firms is not the decisive factor; a fair share of them need to survive and grow. Rampant failure not only diminishes the impact of entrepreneurs but also dissuades potential entrepreneurs from entering the market in the first place.

Having said that, it is quite natural to expect a large number of new and very young firms to fail. This phenomenon is attributed to entrepreneurs not being able to accurately evaluate their own productivity or profitability prior to entry and realizing it only after all the entry costs are sunk … .

The rate of failure

In Australia, about 61 per cent of firms exit during the first ten years. About 24 per cent exit in the first three years. Typically, the exit rate of starting firms peaks soon after the first year and gradually falls as firms grow older. This pattern is sometimes referred to as the inverted-U relationship …

My comment on insolvency law reform

New s 588HA of the Corporations Act usefully requires a review of safe harbour to be undertaken after 2 years.  Such reviews have long been advocated by Murrays Legal for many types of law reform; although the need for the body recommended [rec 17] by the 2010 Senate Report that would be “responsible for gathering, collating and analysing data on a range of corporate and personal insolvency matters” is not forgotten.

Section 588HA requires the review to be undertaken by 3 persons who with appropriate qualifications. Economic input of the nature explained here is needed, not only in relation to safe harbour but in many other aspects of the insolvency regime.  While the typical reasons for having insolvency laws tend to focus on the legal aspects, the economic need to deal promptly efficiently and effectively with under-used assets and resources is a major economic rationale.  Whether our insolvency laws meet those criteria is much open to question; in fact, we don’t really know.

As Associate Professor Jason Harris and I have long said, and others, any insolvency reform must have input not only from lawyers and information technology specialists but also, importantly, from economists, with their wide range of expertise and skills.

Note: Any misinterpretations of Dr Bakhtiari’s report in this commentary are my errors alone.

Other references:

Productivity Commission – Business Set-up, Transfer and Closure, December 2015;

Productivity Commission – Business Failure and Change, an Australian Perspective, December 2000

Boosting the commercial returns from research, Department of Education, Department of Industry, 2014

[1] The Business Longitudinal Analysis Data Environment, a new firm level data environment in the ABS that provides operational and financial information on Australian firms and enterprises.

Photo: Alice Springs

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