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Why do Most Firms Die Young?

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Disciplines
  • Economics

Abstract

A model is developed to explain why most firms die in the first few years of trading. A risk averse entrepreneur with initial capital endowment faces a Brownian motion in net worth over time. To balance return (profits growth) and risk (variance of profits) she adopts a portfolio strategy, choosing market positioning to achieve an optimal combination of risk and return at each instant, given her financial and human capital endowments and attitude towards risk. Failure occurs when the firm’s value falls below the opportunity cost of staying in business. The resulting distribution of failure is Inverse Gaussian, implying, for specific parameter values, a positively skewed failure curve of the type observed in practice. In addition the model presents a novel-measure of management human capital (MHC) which implies that high MHC entrepreneurs will have higher absolute and marginal profits growth than low MHC entrepreneurs at given levels of risk. Copyright Springer 2006

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