Business Closure and Financial Loss: Who Foots the Bill? Evidence from German Small Business Closures

Many new firms do not survive the first years in business. Even though, the financial risk for the parties that have a financial stake in the business (i.e. owners, lending institutions and other creditors, such as suppliers) is misleadingly exaggerated by the high closure rates among start-ups: not all start-ups cease operations with a financial loss, nor does closure – in the event of loss –necessarily entail financial pain for every party. Closures happen, for example, because owners pursue opportunities for alternative earnings, such as salaried employment, alternative self-employment or retirement. Yet the decision to pursue alternatives is influenced by costs considerations: low opportunity or high switching costs should increase the probability of a business owner staying in a current business – possibly longer than advisable, which would predict a higher likelihood of financial loss at closure. In contrast to voluntary closures, the link between closure due to bankruptcy or other financial problems with financial loss is obvious. As a consequence, business closure because of bankruptcy should basically be more likely to produce losses than voluntary closure. Owing to their different relationships to a business, creditors are subject to varying probabilities of incurring financial loss. These probabilities depend, for example, in part on informational asymmetries, as not all creditors are privy to the same information about the business and the measures used by these creditors to treat their information deficit. Theoretical arguments suggest that also the reasons for closure affect the financial risk. The central purpose of this paper is thus to test how different reasons for business closure determine who suffers financial loss at closure. Using data from the ZEW Entrepreneurship Study (a unique dataset on business closures in Germany), we determined that closures that take place based on expectations about a business’ future development or because the owner takes a different earning opportunity are less likely to entail losses for creditors. Conversely, closures because of financial problems are correlated with a higher loss probability for involved parties. The findings in this paper have important implications for both entrepreneurs and creditors. They suggest that creditors should help debtors to assess business prospects in order to limit their own loss risk. Such assistance, of course, is also in the interest of entrepreneurs themselves – particularly those who would seek to pursue a new business venture. When an entrepreneur leads a lending institution to suffer losses, the likelihood that he will be able to obtain a new loan for a fresh start drops significantly.

Metzger, Georg (2010), Business Closure and Financial Loss: Who Foots the Bill? Evidence from German Small Business Closures, ZEW Discussion Paper No. 10-026, Mannheim.