The Small Firm Effect and the Quality of Entrepreneurs

This paper argues that the observed small firm effect on the spawning of employee entrepreneurs may be driven by the possibility that small firm employees have acquired specific human capital in industries where new business creation happens to incur low entry costs. To explore the plausibility of this alternative explanation, versus the existing theories for the small firm effect, this paper examines the persistence of the small firm effect on new business survival and the founders’ post-entry occupational choice. Using
employer-employee 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. These results suggest that the higher rate of
entrepreneurial spawning observed in small firms might be largely attributed to lower barriers of entry in sectors clustered by small firms, while related industry experience further facilitates the transition into self-employment for small firm employees.