Institutions and Environment
With appropriate incentive structures, firms can direct activity towards the most productive purposes. Incentive structures include both formal (e.g., law and regulation) and informal institutions (e.g., culture and norms), which largely dictate not only the allocation of entrepreneurial effort in society across activities, but also the aggregate supply of it.
- Formal institutions (e.g., property rights, taxation, bankruptcy, financial institutions, competition policy, and labor market regulations) and informal institutions (e.g., culture, norms, and social movements) not only highly influence business decisions but also lay important incentives for both entrepreneurs and innovative firms (Hall and Jones 1999) (North 1990) (Schumpeter 1942) (Scott 1995).
- Research shows that formal institutions, such as the protection of private property rights, are of fundamental importance for economic growth and entrepreneurship (Acemoglu and Johnson 2005) (North 1981) (Rodrik, Subramanian, and Trebbi 2004) (Rosenberg, Birdzell, and Mitchell 1986). Other research on informal institutions show they can affect entrepreneurship in important ways by shaping the definition of entrepreneurship as an "appropriate" kind of economic behavior, and that culturally embedded institutional notions of the appropriateness of entrepreneurship are key forces in shaping decisions to found new organizations (Brandl and Bullinger 2009) (Tolbert, David, and Sine 2011).
- The specific impact of institutions on entrepreneurship can vary by time, geography, social networks, and industry (Brandl and Bullinger 2009) (Khessina and Carroll 2008) (Romanelli and Khessina 2005) (Sine and Lee 2009) (Sorenson and Audia 2000) (Tolbert, David, and Sine 2011).
- Institutions are also significantly influenced by entrepreneurs (Henrekson and Sanandaji 2011) (Li, Feng, and Jiang 2006) (Scott 1995). Unpredictable entrepreneurial responses to these institutions will force continual amendment of the institutional environment.
- While progress has been made in understanding the relationship between institutions and entrepreneurship, there remain many opportunities for further investigation, e.g., how cross-country institutional differences matter for firm formation and growth in entrepreneurship, the difference between policies fostering firm formation and policies fostering innovation and growth, and how educational institutions play a role in promoting or hindering entrepreneurship, among others.
Implications for Practice and Policy
- Policymakers should work towards increasing their understanding of how formal and informal institutions and the business environment in general as shaped by their policies impact entrepreneurial effort and productivity across the economy.
- Policymakers should be aware whether the intention of a policy is aimed at promoting innovative new firms (i.e., firms that either deliver new products or deliver existing products in new ways) or founding of replicative firms (i.e., firms that replicate existing businesses). Policy that promotes the quantity of new firm formation may not necessarily be the best policy that promotes the quality (e.g., innovation and growth) of new firms.
- Despite increasing diffusion and harmonization of institutions in some places (e.g., adoption of U.S.-inspired bankruptcy laws in Japan), large institutional differences remain across geographies, and entrepreneurs would find it prudent to take environment and institutions into account as they make their business decisions. The non-market environment can have significant impact on a firm’s market activities, and firms can also help to shape the non-market environment.
- Increased communication among practitioners, policymakers, and academics can enhance collective understanding of institutional gaps and how best to address them, creating a win-win for entrepreneurs, communities, and the economy.
Institutions and the environment, which span formal (e.g., law and regulation) and informal institutions (e.g., culture and norms), play a major role in directing productive entrepreneurship, as together they help establish incentive structures and their governance. Such incentives can largely dictate the allocation of entrepreneurial effort across activities in society as well as the aggregate supply of it. As current entrepreneurship research and policy are particularly interested in new firms that drive growth and innovation, this article highlights the major themes, assumptions, and gaps in our existing understanding of the mutually influencing relationship between institutions and innovative entrepreneurship.
As new and young firms often form the basis of an innovative economy, it is evident that an increasing amount of research and policy focus on this entrepreneurial segment and how to grow and nurture it. There are many types of firm formation, including corporate spinoffs (or spinouts), startup ventures, self-employment, and entrepreneurial spawning (or employee entrepreneurship); however, not all types of firm formation correspond to the notion of Schumpeterian entrepreneurship (Schumpeter 1942).
Following Schumpeter, many scholars in the field of entrepreneurial studies consider the interrelatedness of entrepreneurship and innovation the hallmark of the field, and are interested in the formation of new firms that either deliver new goods or services or deliver existing goods or services using a new (and more efficient) method, or both. In other words, these are innovative firms rather than replicative firms (Baumol 1990). Innovative firms are thought to be the engine of economic growth, but replicative firms are not.
Given that many societies desire to promote productive entrepreneurship, some scholars argue it is critical to have the appropriate incentive structure and environment in place to direct entrepreneurship toward inherently productive purposes (Baumol 1990). The incentive structure determined by "the rules of the game in the society" (North 1990) or "commonly held beliefs and understandings" about the appropriateness of entrepreneurship (Meyer and Rowan 1977) include both formal (e.g., law and regulation) and informal institutions (e.g., culture and norms), which largely dictate not only the allocation of entrepreneurial effort in society across activities, but also the aggregate supply of it (Baumol 1990) (North 1990). While prior entrepreneurship literature have mainly focused on individual- or firm-level traits to explain who becomes entrepreneurs and what explains heterogeneity in entrepreneurial firm performance, it has now become evident that entrepreneurship can only be meaningfully analyzed and understood given the institutional context (or external environment, in general) coupled with such individual-level and firm-level traits.
There are various forms of institutions that may affect entrepreneurship (Busenitz, Gomez, and Spencer) (Kerr and Nanda 2009) (Klapper, Laeven, and Rajan 2006). These include formal institutions such as protection of property rights, taxation, bankruptcy, financial institutions, competition policy, labor market regulations (Hall and Jones 1999), and informal institutions such as culture, norms, and social movements (North 1990) (Scott 1995), among others. The literature surveyed in the following descriptions of formal and informal institutions is not intended to be exhaustive.
Protection of Property Rights
One of the most well-known institutions that directly affects entrepreneurship is protection of property rights. From historical studies to more recent econometric studies, it is now widely recognized that protection of private property rights is of fundamental importance for economic growth and entrepreneurship (Acemoglu and Johnson 2005) (North 1981) (Rodrik, Subramanian, and Trebbi 2004) (Rosenberg, Birdzell, and Mitchell 1986). With secure exclusive private property rights that can be used in voluntary exchanges based on contracts, entrepreneurship is likely to thrive. This follows because successful entrepreneurs know that they will retain the entrepreneurial rents they earn and because specialization and division of labor is greatly facilitated, which broadens the range of potential entrepreneurial discoveries. While protection of property rights may affect all types of firm formation, the strength of intellectual property rights, in particular, plays a critical role in shaping innovation and entrepreneurship (e.g., Anton and Yao 1995; Graham, Merges, Samuelson, and Sichelman 2009; Hellmann 2007; Shane 2004). The protection of property rights can affect both the formation of entrepreneurial firms by lowering entry barriers and the growth of these firms ex post entry.
While the effect of taxation on entrepreneurship has been much discussed in economics, most studies investigate the effect on self-employment, not innovative startups per se. For example, high income taxes may spur self-employment because it is easier to avoid reporting some of their income and possible to shift from labor income taxed at a high marginal rate to corporate income taxed at a lower rate (e.g., Domar and Musgrave 1944, Feldstein and Slemrod 1980, Henrekson and Sanandaji 2011b); however, because such motivations may not be driving the founding of innovative firms, implications should be considered with caution. Instead, because most innovative ventures use stock options as a way to reward employees, and because the efficiency of stock options is highly dependent on the tax code, the effect of taxation on stock options may have more direct impact on entrepreneurial behavior (Core and Guay 2001). This may be because entrepreneurs can attract and retain talented individuals that may not have worked for entrepreneurial startup companies absent appropriate stock options in the first place, and may be able to motivate employees to stay productive and innovative once hired. For example, if the gains on stock options are taxed as wage income when the stock options are tied to employment in the firm this mechanism will lose much of its incentive effects. The situation would be very different if an employee who accepts stock options could defer the tax liability to the time when the stocks were eventually sold. This effect would be further reinforced if there are no tax consequences to the employee upon the grant or the exercise of the option, and if the employee is taxed at a low capital gains rate when the stock acquired from the exercise of the option is sold. In the latter case, the tax risk of the options is pushed back to the government. This accomplishes two things: it increases the potential profit from the stock options and it allows budget-constrained individuals to sell stocks whenever they choose to do so. The United States changed the tax code in the early 1980s along the latter lines, which paved the way for a wave of entrepreneurial ventures in Silicon Valley and elsewhere (Misher 1983).
Another formal institution extensively studied in the literature that may affect entrepreneurship is bankruptcy law (Armour and Cumming 2008) (Fan and White 2003) (Lee, Peng, and Barney 2007) (Paik 2013) (Primo and Green 2011). Bankruptcy is the legal process by which financially distressed firms and individuals resolve their debts. The bankruptcy system is important with regard to entrepreneurship because it dictates the financial consequences of a business failure, which effectively characterizes the cost of exit and affects the likelihood that a bankrupt entrepreneur will begin anew (Armour and Cumming 2008) (Ayotte 2007) (Lee, Yamakawa, and Peng 2008).
In effect, bankruptcy law can determine the cost of entry into entrepreneurship and the degree of risk involved in conducting business. Prior studies find that a more generous bankruptcy law has a positive effect on business formation (Armour and Cumming 2008, Fan and White 2003, Mathur 2009, Primo and Green 2011). For example, an increase in state homestead exemption attracts new businesses in those states (e.g., Fan and White 2003, Mathur 2009, Paik 2013, Primo and Green 2011). Because it is not easy to distinguish innovative entrepreneurial firms from small businesses in these prior studies, scholars have more recently started to investigate the effect of bankruptcy law on the "quality" of entrepreneurship, rather than mere new firm formation rates. For example, Primo and Green (2011) attempt to distinguish the impact of bankruptcy law on self-employment and venture capital funding separately to see how business formation generally and innovative firms specifically are affected differently. Some other examples of recent debate on bankruptcy law and "quality" of entrepreneurship may include the effect of bankruptcy law on innovation output of firms (Acharya and Subramanian 2009).
Besides these formal institutions explicitly stipulated in law and regulations, there are various types of informal institutions that affect entrepreneurship in important ways.
Institutional theory from sociology has mainly investigated this domain. Institutional theory suggests that decisions to create new organizations are social products, shaped by definitions of entrepreneurship as an "appropriate" kind of economic behavior, which can vary across time, space, and social networks (Tolbert, David, and Sine 2011). For example, under certain conditions and in particular places and industries, entrepreneurship becomes normalized and even taken for granted as an accepted activity and an admired career path (Khessina and Carroll 2008) (Romanelli and Khessina 2005) (Sorenson and Audia 2000), whereas in other places—even ones with relevant resources—it does not (Sine and Lee 2009).
The separate literatures on regional variations in founding and ethnic entrepreneurship therefore provide independent pieces of evidence for the argument that culturally embedded institutional notions of the appropriateness of entrepreneurship are key forces in shaping decisions to found new organizations (Brandl and Bullinger 2009) (Tolbert et al. 2011).
In sum, these studies provide evidence that prevailing institutions—consisting of normative expectations and an understanding of acceptable organizational structures and practices—exert considerable influence on decisions about appropriate structures, practices, and behaviors of entrepreneurial ventures, and that studying these influences is therefore critical to studies of entrepreneurship (Tolbert et al. 2011).
Other Institutional Effects
Finally, institutions not only significantly influence entrepreneurship, but they are also significantly influenced by entrepreneurs (Henrekson and Sanandaji 2011) (Li, Feng, and Jiang 2006) (Scott 1995). For example, Henrekson and Sanandaji (2011) point out that evasive entrepreneurship or destructive entrepreneurship can cause change in existing institutions. Politicians cannot design optimal institutions once and for all; unpredictable entrepreneurial responses to these institutions will force them to respond by continually changing and amending the institutional environment.
Li, Feng, and Jiang (2006) use cases of entrepreneurs in emerging market economies that not only play the role of traditional entrepreneurs in the Schumpeterian sense, but also help establish market institutions in the process of their business activities. They call these entrepreneurs institutional entrepreneurs. Tolbert et al. (2011) also introduce various cases where entrepreneurial actions can lead to organizational institutions such as the certification system in the electric power industry (Sine, David and Mitsuhashi, 2007), Vintners Quality Assurance (VQA) in the wine industry (Ierfino 2011), and the Association of Consulting Management Engineers in the management consulting industry (David, Sine, and Haveman 2013).
While there has been significant progress towards identifying the relationship between institutions and entrepreneurship, the research in this area is still under development and there are still numerous gaps in our understanding. For example, scholars have yet to have a clear understanding in why extremely successful innovative firms, such as the likes of Apple, Google, or Tesla, are still mainly concentrated in the U.S. (and not the U.K., Germany, or Japan all of which that have many of the success factors scholars have already identified). That is, how cross-country institutional differences matter for firm formation and growth in entrepreneurship remains an important area for future study.
Understanding also varies somewhat by discipline. The relationship between institutions (or the external environment, in general) and entrepreneurship is a field that has been studied by many scholars across different disciplines. In particular, scholars from economics, finance, strategic management, and sociology have studied entrepreneurship as a phenomenon from their own perspectives. Therefore, entrepreneurship theories have been developed rather independently by these diverse disciplines. Each discipline can make significant progress by learning from one another, but more importantly, entrepreneurship research as a field of study can make significant progress by combining multi-disciplinary approaches into a single study. Strategic management scholars have taken a multidisciplinary approach in their research and have made significant progress in understanding the complex aspects of entrepreneurship.
In particular, the field can make significant progress if future research concentrates in institutions that promote the quantity and quality of entrepreneurship and how entrepreneurship can shape institutions in turn. Given the significance of the field and its practical importance to government policies all around the world today, more studies should be carried out in this domain. There is significant demand to know what works at the aggregate level to promote (innovation-based) entrepreneurship in many industrialized countries today; however, we still lack a complete understanding of how to distinguish between policies fostering (the quantity of) firm formation and policies fostering innovative firms (quality-wise).
For example, the literature is still less clear how policies or practices affect new firm formation (extensive margin) in addition to affecting existing firm's innovation and growth (intensive margin) simultaneously.
- How do social norms or culture affect entrepreneurship, both quantity-wise and quality-wise? What is the role of the media in shaping such culture?
- How do educational institutions play a role in promoting (or hindering) entrepreneurship?
- How much does heterogeneity in legal or political institutions across countries affect entrepreneurial activity today (given the development of the borderless Internet firms)?
These are some research questions that can advance our understanding of institutions and entrepreneurship in the future.
Many authors have relied on hand-collected proprietary data combined with existing datasets for their studies. In other words, scholars have combined the use of publicly available macro-level environment data with micro-level firm formation and growth data to measure entrepreneurship. In general, however, it is hard to come by high-quality firm formation and growth data. Longitudinal data are understandably hard to collect, as private firms (startups) do not have obligation to report much information. Improvement in data availability and quality should be a great source of growth for this field in the future.
The following are some of the popular databases used by authors in this field:
- Kauffman Firm Survey (KFS): A longitudinal dataset provided by the Kauffman Foundation that is available to the public, subject to approval.
- VentureXpert: This database has been widely used for identifying venture capital-backed entrepreneurial firms and their financing activities. Though it is expensive, most research institutions have institutional subscription to the database.
- VentureOne: A similar database to VentureXpert and has extensive coverage about the financing, valuation, and board members of the entrepreneurial firm. Subscription is far more expensive than VentureXpert and most research institutions do not have access to it. Instead, they opt for VentureXpert, which explains its widespread adoption in academic research.
- Government-sponsored databases such as US Census Bureau's Longitudinal Business Database or Longitudinal Employer-Household Database: These datasets are also used, but are not open to public and are subject to background checks to obtain access. Government-collected datasets from other countries (e.g., Sweden, Denmark, Japan) are also used in some studies.
- Global Entrepreneurship Monitor (GEM): This database is publicly available, is also widely used for cross-country studies in entrepreneurial activities, however, it is hard to distinguish whether the firms formed are innovative entrepreneurial firms (e.g., entrepreneurial startups) or just replicative firms (e.g., self-employment), as the distinction can be vastly different across countries, and the database relies much on self-reported survey.
Macro-level data sources on institutions or the environment in general are idiosyncratic, and authors have used their own creative data sources to serve their purpose.
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