Corporate Law and Small Business Finance: Mandatory v. Enabling Rules

Abstract:     
A number of ongoing reforms of corporate law are motivated by the need to stimulate entrepreneurship and business creation. Building on the observations that entry is characterised by sunk costs and that the markets for small business finance are imperfectly competitive, we identify a previously overlooked trade-off that such reforms ought to recognise. The appropriate design of the corporate law depends on whether it is the midstream moral hazard and the ensuing lack of finance or the entrepreneurs' inability to recover sunk entry costs that hamper business creation. In circumstances where the former dominates, well-designed mandatory law ought to be efficiency enhancing. In contrast, if the incentives to enter are weak due to the prospect of facing powerful external financiers in the market for post-entry expansion finance, business creation can be boosted by making the law more enabling. Enabling law increases the effective bargaining power of the entrepreneurs in market conditions where their bargaining position would otherwise be weak. It does so by giving the entrepreneurs a credible threat to expropriate the financiers. To the best of our knowledge, neither this trade-off nor the associated effects of corporate law on entry and entrepreneurship have been considered elsewhere in the literature on mandatory v. enabling rules.

Keywords: Investor protection, start-up financing, entrepreneurship, corporate finance, company law reform

JEL Classification: K2

Accepted Paper Series