The Small Firm Effect and the Quality of Entrepreneurs

Abstract

This paper argues that a negative relationship between firm size and the likelihood of employees entering entrepreneurship could be driven by small firm employees acquiring specific human capital in industries where new business creation incurs lower entry costs. Contrary to the existing theories, this explanation on the small firm effect suggests a short-term rather than the persistent quality difference between entrepreneurs coming from large firms and those from small firms. To explore the plausibility of this alternative explanation, this paper examines the persistence of the small firm effect on new business survival and the founders’ post-entry occupational choice. Using employeremployee matched panel data obtained from Statistics Denmark, I find that the size of entrepreneurs’ prior employers continues to have a negative correlation with the survival of startups for the first three years, but the size effect gradually fades away afterwards. The magnitude of the correlation is largely reduced if the new businesses were formed in sectors that are unrelated to founders’ parent firms. Moreover, entrepreneurs coming from small firms are much more likely to move into unemployment if their first startups did not survive.