Entrepreneurial Optimization of the Timing of Bankruptcy

Abstract:     
Small incorporated firms display different bankruptcy filing characteristics than either large or unincorporated firms. Horvath and Woywode (1996) find that these firms' bankruptcy filings peak earlier (before recessions), their filing ratios are always larger and that they are more solvent than other firms. This article develops a model which could explain those differences. A significant fraction of small firm owners guarantee their firms' debts with their personal wealth. When creditors of their firms deplete the firms' assets, however, they face costs associated with enforcing these guarantees against the entrepreneur's personal wealth, namely the cost of a second bankruptcy procedure. The result is that occasionally, creditors will decide to not enforce their guarantees. This windfall to the entrepreneur--unique to the small incorporated business--is shown to drive bankruptcy filings so that we should expect to observe small firms to be more solvent and file more frequently than others, as well as to file with greater frequency at times of volatility of asset values, a state that may precede recessions.

JEL Classification: G33

working papers series