Destructive Creation at Work: How Financial Distress Spurs Entrepreneurship

Abstract

Why do employees become entrepreneurs? This paper shows that firm financial distress drives the exit of workers to pursue entrepreneurship. In a difference-in-difference setting, I find that, following unexpected industry shocks, employees at relatively more financially levered public firms are more likely to exit to found new firms. These new firms are created because financially distressed firms are less able to retain productive workers who exit to found start-ups. Entrepreneurs exiting financially distressed employers earn higher wages prior to leaving paid employment and after founding start-ups, compared to entrepreneurs exiting non-distressed firms. Consistent with financial distress driving productive workers into entrepreneurship, start-ups created following financial distress have high future employment growth. Distressed firms are less able to retain entrepreneurial workers in part because ex ante contracts restricting employee mobility are not enforceable. In support of this argument, I find that the effect is concentrated in states with weaker enforcement of non-compete agreements. The results suggest that the social costs of distress might be lower than the private costs to financially distressed firms.