Why Bankruptcies May Be Good News For Startups

(By Mark Henricks)

Intuitively, it makes sense to get into a business that others find unattractive because, at the very least, there won’t be many competitors. But that’s not how researchers explain this “bankruptcy = good” phenomenon. Instead they say it’s because startups in fields with bad reps have to actually be better in order to get funding.

Detroit did it. JCPenney may do it. American Airlines is in the middle of it now. Kodak just emerged from it.

It’s bankruptcy, of course, and while it may be bad news for lenders, shareholders, employees and suppliers, a well-known firm’s decision to seek protection from creditors could be just what an entrepreneur interested in starting or expanding a business should be looking for.

That’s the counterintuitive upshot of recent research from researchers at the University of Chicago and Stanford. Nonconformity—going against the market trends—is a smart move, according to the paper. After analyzing a number of software companies, researchers found that the ones that enter a market space after big-name bankruptcies are likely to stick around, while those that jump into a space after a high-profile venture capital funding are especially likely to leave the industry.

Bucking The System

The notion that it can be smart to go against the flow was colorfully expressed by Warren Buffett with his advice for stock market investors to “be fearful when others are greedy and greedy when others are fearful.” But Buffett was talking about the wisdom of buying shares of financially sound, well-established companies with strong competitive positions at a time when investors’ negative sentiments had depressed their values unreasonably.

That’s not the same as starting a company in a space where another, perhaps much larger competitor has already failed. Nor is it like taking a pass over entering a field where investors are clamoring for places to put their money. But those are still both smart moves, according to the new research—they’re just smart for reasons other than those Buffett saw.

Intuitively, it makes sense to get into a business that others find unattractive because, at the very least, there won’t be many competitors. But that’s not how researchers explain this “bankruptcy = good” phenomenon. Instead they say it’s because startups in fields with bad reps have to actually be better in order to get funding.

“When other organizations in a market experience positive events, the market becomes more attractive; when they experience negative events, the market seems less so,” the researchers note. This translates into the willingness of investors to fund entries into markets where the outlook is rosy—they apply less stringent criteria to candidates for financing in these booming industries. But when the environment is clouded by a recent massive failure, the standards become even tighter than usual.

“Markets that seem especially promising have lower entry selection thresholds, and many organizations will enter. But markets that do not seem viable have stringent thresholds and entries are thus rare,” the researchers say. So if you can get money from investors to get into a tough business, you probably have the concept, management, processes and products to see you through. On the other hand, it’s no secret that when an investing stampede is on, many companies with flimsy business models get funded quickly, only to go under almost just as fast.

If you’re thinking that it might be easier to start a company in the department store field that’s proving to be so challenging for JCPenney, consider that it probably will, in fact, be harder to get financing than if you were entering a more trendy field such as mobile e-commerce. The good news is, if you actually do get funding for a new department store, your long-term outlook is probably going to be better than the typical mobile e-commerce fledgling.

Exceptions To The Rules

There are some qualifiers to the study about nonconformist entrepreneurs. To begin with, the researchers confined their empirical research to software companies. Specifically, they looked at the period from 1990 through 2002, splitting the industry into as many as 400 sub-markets, from systems software to customer relationship management.

They found that software firms entering trendy fields tended to disappear from the market quickly—sometimes in as little as a year. But it’s not clear whether the software results would transfer to most or many other businesses. For instance, software has more venture activity than most, so it’s a bigger influence there than in, say, waste disposal. Furthermore, the researchers found only modest evidence that negative events influenced many erstwhile competitors to stay away.

But despite their limitations, these findings do suggest that the normal instinct to avert your eyes from the next American Airlines or Kodak might be a good one to suppress, specifically because only a few others will do that. “Although conformity may seem to be the safe bet, when it comes to herding behavior in markets,” the researchers write, “this study indicates that nonconformity may be a more sustainable strategy.”

(Source: Openforum)

“Opinion pieces of this sort published on RISE Networks are those of the original authors and do not in anyway represent the thoughts, beliefs and ideas of RISE Networks.”

RISE NETWORKS

"Nigeria's Leading Private Sector and Donor funded Social Enterprise with deliberate interest in Technology and its relevance to Youth and Education Development across Africa. Our Strategic focus is on vital human capital Development issues and their relationship to economic growth and democratic consolidation." Twitter: @risenetworks || Facebook - RISE GROUP || Google Plus - Rise Networks