1

Explaining New Venture Failure: A Competence-based Approach

Paper submitted to the AIMS 2013 Conference

Capacites Dynamiques et Innovation

April 11-12, 2013 Nice (France)

by:

Jörg Freiling Sven M. Laudien

Prof. Dr. Jörg Freiling Prof. Dr. Sven M. Laudien* Full Professor Interim Full Professor University of Bremen Otto von Guericke University Magdeburg Chair in Small Business & Entrepreneurship Chair in International Management Wilhelm-Herbst-Str. 5 Universitätsplatz 2 D-28359 Bremen D-39106 Magdeburg email: freiling@uni-bremen.de email: sven.laudien@ovgu.de phone: +49-421-218-66870 phone: +49-391-67-18789 fax: +49-421-218-66902 Fax: +49-391-67-11162 * Corresponding Author

Bremen/Magdeburg, March 25th, 2013

2

Explaining New Venture Failure: A Competence-based Approach 1 Introduction Although the 5-year survival rate of new ventures is less than 50 percent on average (Fritsch & Weyh, 2006) and ten years after starting up only ten percent of the ventures remain in the market (Timmons & Spinelli, 2004), entrepreneurs are optimistic enough to start a business and to run it with a rather high level of involvement. Given that entrepreneurs believe in their own success based on their ideas and the skills at hand (Cooper et al., 1994), new ventures face manifold obstacles like liabilities of newness and adolescence (Stinchcombe, 1965), liabilities of smallness (Aldrich & Auster, 1986) or – in case of cross-border activities – liabilities of foreignness (Hymer, 1976; Zaheer, 1995) which may threaten their long-term survival. Furthermore, entrepreneurs may overestimate the set of skills and competences at hand which often paves the way to failure. Notably, failure does not stand at the forefront of entrepreneurship research since literature mainly focuses on identifying entrepreneurial key success factors (e.g. Stuart & Abetti, 1987; Roure & Keely, 1990). Whenever failure is directly addressed, myopic explanations such as financial bottlenecks etc. come into play. This, however, does not shed light on the final reasons of entrepreneurial failure (Bruno & Leidecker, 1988; McGrath, 1999; Zacharakis et al., 1999; Shepherd, 2003; Cope et al., 2004) but addresses typical symptoms of failure. We argue that success and failure are not two sides of the same coin (Castrogiovanni, 1996). Many ways may lead to success. In contrast, failure often can be traced back to a limited number of factors that are highly interrelated and make up typical organizational trajectories. Although every single case might be different to some extent (Audretsch & Mahmood, 1995; Mata et al., 1995), there are many commonalities that form a pattern of new venture failure (Thornhill & Amit, 2003). Following literature, external conditions might play a role in the process of entrepreneurial failure. Additionally and in line with research on resources and competences (Barney, 1991, Teece et al. 1997) we believe that deficiencies in skill and capability endowment and a slow pace of learning considerably contribute to new venture failure (Bates, 1985 & 1990; Stuart & Abetti, 1990; Brüderl et al., 1992; Herron & Robinson, 1993; Chandler & Hanks, 1994; Storey, 1994; Lee et al., 2001, Stam et al., 2010). Against this background, we raise our research question: In which way and to what extent does the set of organizational competences influence the risk of failure of new ventures? 2 Theoretical Background Selecting a sound theoretical background requires a thorough review of the most striking factors of failure according to previous research. Following Audretsch & Mahmood (1995) and Mata et al. (1995), a low initial firm size, a market entry under unfavorable conditions and the ownership structure are important factors that explain venture failure. Other surveys point to unbalanced skills of the entrepreneur (Zacharakis et al., 1999), dependence on key accounts (Venkataraman et al. 1990), and an insufficient way of planning (Duchesneau & Gartner, 1990). In a nutshell, the theory employed should be able to address these reasons for entrepreneurial failure and their potential inter-relatedness.

3

Furthermore, entrepreneurial endeavours take place in particular settings: Every entrepreneur is equipped with an individual (and incomplete) set of information, knowledge, skills, and ambition. Entrepreneurs act in uncertain and oftentimes complex environments and typically strive for satisfying their economic needs (Campbell, 1992). Besides that, the findings from goal setting theory (e.g. Locke & Latham, 2002) tell us that autonomy and self-realization rank among the top motives that drive entrepreneurial action and start-up processes (Kuratko et al., 1997). Facing this constellation we employ an approach that belongs to the research on dynamic capabilities and organizational competences, namely the so-called Competence-based Theory of the Firm (CbTF) according to Foss and Ishikawa (2007) and Freiling et al. (2008). The theory aims at explaining corporate survival and not primarily sustaining competitive advantage as e.g. the Dynamic Capability Approach (Teece et al., 1997) does. When addressing entrepreneurial failure, this branch of competence research seems to be appropriate. According to CbTF, firms are open systems that are permanently in touch with external parties. Figure 1 portrays the interfaces of the new venture to the business environment and at the same time illuminates issues of internal coordination. In this context, some potential bottlenecks appear that may explain why entrepreneurs are unable to maintain competitiveness. These bottlenecks can be internal elements of the value-added system of the firm as portrayed in the middle of figure 1, access to external assets, or mechanisms that drive and/or develop this system. Thus, CbTF considers both internal and external reasons for failure and the run of events over time.

Figure 1: Open System View of the Firm Source: Sanchez & Heene (1996: 41). Commencing with the elements of the value-added system, there might be bottlenecks when the resource endowment is simply too scarce to be competitive. In this context, liabilities of smallness oftentimes appear when the new venture is equipped with an insufficient set of e.g. financial capital, human resources or market assets (e.g. market intelligence, reputation). The bottleneck can be located in one category of assets, as empirical surveys (Audretsch & Mahmood, 1995) quite often reveal. More relevant seems to be the case when bottlenecks are an inter-related problem of the entire resource endowment, so that they have to be fixed

4

coevally. We propose that inter-related resource and competence shortcomings principally overtax new ventures and increase the likelihood of entrepreneurial failure (P1). CbTF tells us that the resource endowment of new ventures is constantly in flux. Accordingly, entrepreneurs are often in a position to overcome critical bottlenecks. This, however, requires entrepreneurial foresight and action as well as the activation of certain mechanisms that reinforce the young firm’s resource system. One important cornerstone in this regard is the acquisition of external assets called ‘firm-addressable resources’. Cohen & Levinthal (1990) highlighted the pivotal role of the so-called ‘absorptive capacity’. Absorptive capacity consists of three interconnected elements: recognition, integration, and application of external knowledge to commercial needs (Cohen & Levinthal, 1990). We propose that the lower the absorptive capacity, the worse the venture is able to fill resource gaps and to fuel the process of resource and competence building (Sanchez & Heene, 1996) so that entrepreneurial failure is more likely (P2). Firm-addressable resources are not specified as for the resource owner. Different from that, figure 1 highlights the interface between the firm and the product market. In this context, firms constantly learn by participating in the market process and are able to reconfigure their resource endowment for the sake of closeness to the customers. Once again, due to subjectivism there is no automatism that fuels organizational renewal by learning in the market place. Instead, the firm’s personnel (with contact to the customer) might manage transactions individually. The same holds true for internal reconfiguration processes at the different layers of the value-added system of the new venture. Thus, some ventures perform well, get more information in the market and are more capable in drawing the right conclusions (and implementing the consequences), while others perform badly. We propose that a low intensity and speed of learning in markets is negatively related to resource and competence building and increases the likelihood of entrepreneurial failure (P3). CbTF allows for addressing the steering mechanisms employed in ventures. In figure 1, we refer to the strategic logic, sometimes also called ‘dominant logic’ (Prahalad & Bettis, 1986), and the management processes. Both system elements are closely interrelated. The strategic logic consists of previously learned mental models that help decision-makers select information, get oriented in a complex and dynamic world, and make sound decisions by activating available knowledge. Since the business environment often and sometimes radically changes, the strategic logic must be flexible enough to consider novel cause and effect structures relevant to performance measure. We propose that rigid strategic logics cause misinterpretations and managerial misconceptions that pave the way to entrepreneurial failure (P4). 3 Methodology As shown above, we employ CbTF to explain the link between shortages of new venture’s competences and failure and develop research propositions.To make a first reality check of the propositions, we make use of a longitudinal case study approach and present results of three in depth case studies we conducted in 2010 and 2011. Every case study focuses a failed new venture and its development from foundation to bankruptcy as our measure of failure. For the sake of triangulation, the case studies are based on at least two semi-structured interviews, one with the founder and one with investors, and the review of company related material (business plans etc.). Each of the interviews took more than two hours time and was carefully conducted to respect the standards of qualitative research (Corbin & Strauss, 1990). We go beyond the single case studies by analyzing cross-case patterns (Yin, 2008). These

5

patterns are of particular interest following the aim of understanding how and to what extent specific internal factors contribute to new venture failure. 4 Results Our case studies suggest that three main aspects are of relevance in the context of failure:

(1) systematic misinterpretations of information that are based on a lack of competences

and over-confidence, this insight is in line with P1 and P2; (2) an insufficient understanding of the market and in particular the buying process of

customers; this result is backs up P3; (3) internal conflicts between the entrepreneur(s) and other shareholders; this finding is

related to P4. The findings illustrate that specific role competences play to explain the failure process of new ventures. 5 Implications for Entrepreneurship Research and Business Practice Our paper advances research by identifying factors that influence the process of entrepreneurial failure. Moreover, we outline the mechanisms and causal chains that determine the impact of these individual factors on the process of failure. We could highlight the crucial role of governance conflicts among entrepreneurs and other shareholders. These conflicts might paralyze the entrepreneurial efforts and lead to path-breaking moves into the direction of bankruptcy. Understanding business partners, in particular customers, from a psychological point of view and drawing the right conclusions as for redefining the business concept is another core issue that is closely connected with skills and dynamic capabilities at hand. The same holds true as for interpreting signals from the business environment and to estimate the consequences as to the venture. It turns out that particular skills and competences stand at the forefront of venture survival or failure. Moreover, we challenge the common view on new venture failure which suggests that the reasons for failure are the mirror image of the critical factors of success. It is up to on-going qualitative and quantitative research to specify our research propositions.

References Aldrich, H. E., & Auster, E. 1986. Even dwarfs started small: liabilities of size and age and

their strategic implications. Research in Organizational Behaviour, 8(2): 165-198. Audretsch, D., & Mahmood, T. 1995. New firm survival: new results using a hazard function.

Review of Economics and Statistics, 77(1): 97-103. Barney, J. B. (1991). Firm resources and sustained competitive advantage. Journal of

Management, 17(1): 99-120. Bates, T. 1985. Entrepreneur human capital endowments and minority business viability.

Journal of Human Resources, 20(5): 540-554. Bates, T. 1990. Entrepreneur human capital inputs and small business longevity. Review of

Economics and Statistics, 72(4): 551-559. Brüderl, J., Preisendörfer, P., & Ziegler, R. 1992. Survival chances of newly founded business

organizations. American Sociological Review, 57(2): 227-242. Bruno, A. V., & Leidecker, J. K. 1988. Causes of new venture failure: 1960s vs. 1980s.

Business Horizons, 31(6): 51-56.

6

Campbell, C. A. 1992. A decision theory model for entrepreneurial acts. Entrepreneurship: Theory & Practice, 17(1): 21-27.

Castrogiovanni, G. J. 1996. Pre-start-up planning and the survival of new small businesses: theoretical linkages. Journal of Management, 22(6): 801-822.

Chandler, G. N., & Hanks, S. H. 1994. Founder competence, the environment, and venture performance. Entrepreneurship – Theory and Practice, 18(3): 77-89.

Cohen, W. M., & Levinthal, D. A. 1990. Absorptive capacity: a new perspective on learning and innovation. Administrative Science Quarterly, 35(1): 128-152.

Cooper, A. C., Gimeno-Gascon, F. J., & Woo, C. Y. 1994. Initial human and financial capital as predictors of new venture performance. Journal of Business Venturing, 9(5): 371-395.

Cope, J., Cave, F., & Eccles, S. 2004. Attitudes of venture capital investors towards entrepreneurs with previous business failure. Venture Capital, 6(2/3): 147-172.

Corbin, J., & Strauss, A. (1990). Grounded theory research: procedures, canons, and evaluative criteria. Qualitative Sociology, 13(1): 3-21.

Duchesneau, D. A., & Gartner, W. B. 1990. A profile of new venture success and failure in an emerging industry. Journal of Business Venturing, 5(5): 297-312.

Foss, N. & Ishikawa I. 2007. Towards a dynamic Resource-based View: insights from Austrian Capital and Entrepreneurship Theory. Organization Studies, 28(5): 749-777.

Freiling, J., Gersch, M., & Goeke, C. 2008. On the path towards a Competence-based Theory of the Firm. Organization Studies, 29(8-9): 1143-1164.

Fritsch, M., & Weyh, A. 2006. How large are the direct employment effects of new businesses? – An empirical investigation. Small Business Economics, 27(2): 245-260.

Herron, L., & Robinson, R. B. 1993. A structural model of the effects of entrepreneurial characteristics on venture performance. Journal of Business Venturing, 8(3): 281-294.

Hymer, S. H. 1976. The international operations of national firms, Cambridge, MA: MIT Press.

Kuratko, D. F., Hornsby, J. S., & Naffziger D. W. 1997. An examination of owner‘s goals in sustaining entrepreneurship. Journal of Small Business Management, 35(1): 24-33.

Lee, C., Lee, K., & Pennings, J. M. 2001. Internal capabilities, external networks and performance: a study on technology-based ventures. Strategic Management Journal, 22(6/7): 615-640.

Locke, E. A., & Latham, G. P. 2002. Building a practically useful theory of goal setting and task motivations: a 35-year odyssey. American Psychologists, 57(9): 705-717.

Mata, J., Portugal, P., & Guimarães, P. 1995. The survival of new plants: start-up conditions and post-entry Evolution. International Journal of Industrial Organization, 13(4): 459-481.

McGrath, R. 1999. Falling forward. Real options reasoning and entrepreneurial failure. Academy of Management Review, 24(1): 13-30.

Prahalad, C. K., & Bettis, R. A. 1986. The dominant logic: a new linkage between diversity and performance. Strategic Management Journal, 7(6): 485-501.

Roure, J.B., & Keeley, R.H. 1990. Predictors of Success in New Technology Based Ventures. Journal of Business Venturing, 5(3): 201-220.

Sanchez, R., & Heene, A. 1996. A systems view of the firm in competence-based competition. In R. Sanchez, A. Heene, & H. Thomas (Eds.), Dynamics of competence-based competition: Theory and practice in the new strategic management: 39-62. Oxford: Elsevier.

Shepherd, D. A. 2003. Learning from business failure. Propositions about the grief recovery process for the self-Employed. Academy of Management Review, 28(2): 318-329.

Stam, E., Thurik, R., & van der Zwan, P. 2010. Entrepreneurial exit in real and imagined markets. Industrial and Corporate Change 19(4): 1-31.

Stinchcombe, A. L. 1965. Social structures and organizations. In J. G. March (Ed.), Handbook of Organizations: 142-193. Chicago, IL: Rand-McNally.

7

Storey, D. J. 1994. Understanding the small business sector. London: Thomson Learning. Stuart, R. W., & Abetti, P. A. 1987. Start-up ventures: towards the prediction of initial success.

Journal of Business Venturing, 2(3): 215-230. Teece, D. J., Gary, P., Amy, S., 1997. Dynamic capabilities and strategic management.

Strategic Management Journal, 18(7): 509-533. Thornhill, S., & Amit, R. 2003. Learning about failure: bankrupcy, firm age, and the resource-

based view. Organization Science, 14(5): 497-509. Timmons, J. A., & Spinelli, S. 2004. New venture creation: entrepreneurship for the 21st

century, Boston, MA: McGraw-Hill/Irwin. Venkataraman, S., Van de Ven, A. H., Buckeye, J., & Hudson, R. 1990. Starting up in a

turbulent environment: a process model of failure among firms with high customer dependence. Journal of Business Venturing, 5(5): 277-295.

Yin, R. K. 2008. Case study research: design and methods, 4rd ed., London: Sage. Zacharakis, A. L., Meyer, G. D., & DeCastro, J. 1999. Differing perceptions of new venture

failure: a matched exploratory study of venture capitalists and entrepreneurs. Journal of Small Business Management, 37(1): 1-14.

Zaheer, S. 1995. Overcoming the liability of foreignness. Academy of Management Journal, 38(2): 341-363.