Learning About Failure: Bankruptcy, Firm Age, and the Resource-Based View

Systematic differences in the determinants of firm failure between firms that fail early in their life and those that fail after having successfully negotiated the early liabilities of newness and adolescence are identified. Analysis of data from 339 Canadian corporate bankruptcies suggests that failure among younger firms may be attributable to deficiencies in managerial knowledge and financial management abilities. Failure among older firms, on the other hand, may be attributable to an inability to adapt to environmental change. (Liability of Newness; Resource-Based View; Bankruptcy) Introduction Firms are at the greatest risk of failure when they are young and small. Beyond an early peak in mortality rates, often described as the liability of adolescence, exit rates monotonically decline to a positive asymptote (Carroll 1983, Freeman et al. 1983, Sorensen and Stuart 2000). While much prior research has focused on the age-mortality relationship, the mechanics of firm failure remains an understudied phenomenon (Baldwin et al. 1997, Bruderl et al. 1992, McGrath 1999). Given that the incidence of exit varies as a function of firm age, what is it about firms at different ages that leads to the observed pattern of failure? The present research seeks to answer this question by examining determinants of failure within a sample of bankrupt enterprises. Rather than examining which firms exit in contrast to those that do not, we evaluate causes of failure among firms that exited the economy at different ages. By so doing, we are able to get beyond the observed age-mortality relationship and begin to understand why young firms fail at consistently higher rates, and also why failure continues to haunt firms that have survived their initial liabilities of newness and smallness. Bankruptcy occurs when firms lack sufficient capital to cover the obligations of the business (Boardman et al. 1981). For new firms, the critical challenge then is to establish valuable resources and capabilities that lead to the generation of positive cash flow before initial asset endowments are depleted (Levinthal 1991). Considerable attention has been paid to early failures (new and adolescent firms). Research into large, dramatic megaflops has also been advanced in the literature (D’Aveni 1989, Hambrick and D’Aveni 1988). However, though many firms exit between these extreme positions, there is a considerable gap in our understanding of why. This paper examines, in some detail, failure across a wide range of firm ages. We suggest that underlying age-variant processes within organizations have a direct bearing on mortality risk. Age is an easily observable characteristic, but it may not be age that matters; rather, it is how well a firm’s resources and capabilities are aligned with the demands of the competitive environment (Amit and Schoemaker 1993). Young firms strive to develop a competitive edge. Many fail and exit when their internal asset stocks are exhausted. Others successfully develop resources and capabilities that enable them to survive beyond infancy and adolescence. The development of a viable competitive position, whether deliberate (e.g., investment in specialized assets) or inadvertent (e.g., due to path dependency or causal ambiguity), may subsequently expose firms to mortality risks if the competitive landscape changes and the well-founded organizational assets hinder adaptation to the new environment (Hannan and Freeman 1977, 1984; Leonard-Barton 1992). We thus expect to observe different causal mechanisms between firms that fail early and those that fail at a later stage. Young failures should be attributable to inadequate resources and capabilities (relative to initial endowments). Older failures should be attributable to 1047-7039/03/1405/0497 1526-5455 electronic ISSN Organization Science © 2003 INFORMS Vol. 14, No. 5, September–October 2003, pp. 497–509 STEWART THORNHILL AND RAPHAEL AMIT Bankruptcy, Firm Age, and the Resource-Based View a mismatch between resources and capabilities and the demands of the competitive environment. These internal processes will manifest themselves in nonviable business models, i.e., those that fail to generate positive cash flow. We evaluate the general proposition that the causes of failure vary as a function of firm age with unique data from a sample of Canadian bankruptcies. By examining instances of bankruptcy in some detail, we are able to extend our understanding of mortality dynamics beyond the scope of age, size, and population density mechanisms. Specifically, we examine the relationship between firm age at failure and firm-level resources and capabilities, along with industry competitive conditions. The data provide support for our contention that failure is attributable to different reasons at different firm ages. Failure among young firms is attributed to deficiencies in general management skills, while an evolving competitive environment is identified as a significant influence in the demise of older organizations. These findings are consistent with the expectations of the resourcebased view, and complementary to population-level studies of mortality. Our results reinforce the importance of resource and capability development by young firms as well as confirming the hazards of rigidity and inertia among more established firms. Theory The resource-based view of the firm depicts firms as heterogeneous bundles of idiosyncratic, hard-to-imitate resources and capabilities (e.g., Barney 1991; Conner 1991; Rumelt 1984, 1991; Wernerfelt 1984). Amit and Schoemaker define resources as “stocks of available factors that are owned or controlled by the firm” (1993, p. 35). Capabilities are “information-based, tangible or intangible processes that are firm-specific and are developed over time through complex interactions among the firm’s resources” (1993, p. 35). Competitive advantage can be derived from a firm’s resources and capabilities to the extent that they are valuable, rare, inimitable, and organized to be exploited (Barney 1991). Of these elements, value and rarity are necessary but insufficient in the pursuit of competitive advantage. It is the presence of isolating mechanisms (Rumelt 1984, 1987) that completes the equation. Resources themselves can be inimitable (e.g., due to causal ambiguity or well-protected intellectual property) or the nature of the organization and its managerial processes can deter imitation. Management has been specifically identified in the literature as a source of competitive advantage (Castanias and Helfat 1991, Coff 1997). Teece et al. concur, asserting that a firm’s competitive position derives from “its managerial and organizational processes, shaped by its (specific) asset position, and the path available to it.” (1997, p. 518). The critical role of organizational routines was articulated by Stinchcombe (1965) in his seminal paper on the liability of newness. He identified four aspects of new organizations that make them more prone to failure than are older, more established organizations: (a) new organizations must get by with general knowledge until members learn new, specific roles, and functions; (b) during the role identification and formation process, there may be conflict, worry, and inefficiency; (c) relations with outside individuals and organizations must be forged, and an initial lack of trust may be a liability; and (d) new organizations lack stable ties with the customers they wish to serve. In addition to the organizational liabilities noted by Stinchcombe, young firms may also lack knowledge about what they can do or should do (Jovanovic 1982, Lippman and Rumelt 1982), or may not be sufficiently endowed with the requisite resources to execute their strategy (Lussier 1995, Venkataraman et al. 1990). Fichman and Levinthal (1991) suggest that the liability of newness is not a monotonically decreasing function of firm age, but that there is an initial “honeymoon” period during which initial assets buffer the new organization. They argue that variations in the levels of initial assets affect the way time affects mortality rates. The time dependence occurs because the longer an organization survives (due to initial capital endowments), the more it will be able to develop relationship-specific capital and adapt to the environment. Although the resource-based view has principally been employed in the study of above-normal performance, it is instructive to apply its tenets in the context of below-normal performance. Superior performance is more likely when resources and capabilities are aligned with strategic industry factors—characteristics of the competitive environment that are determinants of firmlevel profitability (Amit and Schoemaker 1993). Conversely, we suggest that failure is more likely when there is misalignment between what a firm can do and what the competitive environment requires. Managers of new firms are able to observe the competitive environment before entry into a particular market. Except for very rare circumstances, new entrants must take competitive conditions as exogenous and craft their strategies accordingly. The ability to generate positive operating cash flows is a function of a firm’s resources and capabilities—both their initial endowments and those that are developed in the course of 498 Organization Science/Vol. 14, No. 5, September–October 2003 STEWART THORNHILL AND RAPHAEL AMIT Bankruptcy, Firm Age, and the Resource-Based View doing business. The challenge of survival when young is exacerbated by resource constraints and the absence of established organizational routines. Younger firms may have great difficulty generating sufficient revenue while concurrently dealing with start-up costs that older enterprises have long since absorbed. Firms that survive through the early years face very different issues than do young enterprises. As noted by Aldrich and Auster, “the major problem facing smaller and younger organizations is survival, whereas larger and older organizations face the problem of strategic transformation” (1986, p. 193). The established routines of older organizations, which in many cases were critical to their initial survival, can become liabilities in the face of changing competitive conditions (Hannan and Freeman 1984). Organizational ecology asserts that the environment will select out unfit organizations, and that the ability to survive over time is both a function of whether an organization is suited to the current environment and its ability to adapt appropriately if the environment evolves. Misalignment with the environment may expose firms to a liability of obsolescence (Barron et al. 1994). Whether an organization ages well or badly thus depends on whether the effects of learning over time result in increased (positive) competence or increased (negative) rigidity (Sorensen and Stuart 2000). In many instances, managers simply do not acknowledge that previously successful strategic postures have become uncompetitive (Harrigan 1985, 1988). Amburgey et al. (1993) noted that while older organizations may be severely affected by change, they are often well suited to withstand shocks by virtue of their accumulated asset stocks. Selection due to environmental change should affect those firms that lack the ability to change as required by the evolution of their market or industry context. The tension between resource slack and efficiency is well known. In stable environments, the efficiency of older organizations should be an asset; however, this can quickly become a liability in unstable or uncertain markets. There is some irony to be found in the observation that the very qualities of resources and capabilities that confer competitive advantage—inimitability and organization—may be the very ones that instill organizations with inertia and consequently limit their adaptability. Commitment to an expensive, dedicated production facility (Ghemawhat 1991) or a specific technology regime (Christensen 1997) can lock a firm into a competitive position from which it may be very difficult to deviate. The nature of isolating mechanisms may imbue a firm with core rigidities that subsequently constrain the options and paths available to it (Leonard-Barton 1992). Resource and capability development can confer survival advantage when firms are young, and yet expose the same firms to threats of obsolescence in when they are more mature. The commonly observed pattern of exit rates as a function of firm age is presented in Figure 1. The high mortality rate among young firms, and the lower exit rates among older firms, is consistent with a model of resource deficiencies early in life and rigidity later. This interpretation extends both the resource-based view and the population ecology perspective on firmfailure dynamics. For any firm, bankruptcy will occur when negative cash flow erodes available asset stocks to the point where creditors cannot be satisfied. For young firms with a given initial capital endowment, having resources and capabilities that are well matched to the demands of the competitive environment will enhance the prospects of initial survival. For older firms, sustaining the connection between internal resources and capabilities and external strategic industry factors is what matters. If firms fail because of an inability to adapt to changing competitive circumstances, this represents a significantly different process of failure than that articulated by the liability of newness. As presented in Figure 1, age is not the prime determinant of mortality, despite the strong correlative evidence that age is a strong predictor of failure. Instead, age is a proxy for internal organizational processes that evolve over time. This leads to our first hypothesis. Hypothesis 1 (H1). Failure of young firms will be attributable to different causes than failure of older firms. As depicted in Figure 1, we propose that young organizations are more likely to suffer from resource and Figure 1 Firm Age and Mortality Risk