The influence of institutional development on the legitimation of start-ups

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NIVERSITEIT VAN

A

MSTERDAM

Master Thesis

The Influence of Institutional Development on the

Legitimation of Start-ups

Name: Bc. Natália Kafková Faculty of Economics and Business Student number: 10828028 MSc. in Business Administration Supervisor: Dr. Ilir Haxhi International Management Track Second Reader: Dr. Rene Bohnsack Academic Year: 2014/2015

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Statement of Originality

This document is written by Bc. Natália Kafková who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Acknowledgments

I would like to thank all the people, who helped me during the process of writing my thesis. Special appreciation goes to Dr. Ilir Haxhi for his professional guidance and valuable advice and comments during this period. I would also like to express my gratitude to my whole family and my friends for their endless love and support.

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Abstract

This study explores the relationship between the institutional development and the legitimation of start-ups. Aldrich and Foil (1994) argue that the legitimation is one of the key assets determining the performance of start-ups as well as their eventual success or failure, while Christmann, Day and Yip (1999) state that the level of institutional development is also one of the factors of companies’ performances. Taking both perspectives together, this master thesis assumes that there is a positive relationship between the level of institutional development and the legitimation of start-ups. More specifically, we argue that different economic, financial, political and social factors of institutional development influence the amount of capital, the number of capital providers and their reputation which are perceived as indicators of legitimized organizations. For a sample of 261 companies from 24 countries we test the eight proposed hypotheses while controlling for industry-level, country-level and firm-level variables. The results indicate that some of the parameters of the institutional development, i.e. gross domestic product, intellectual property rights, ease of doing business and strength of legal rights, in fact do contribute to the legitimation while the rest, i.e. research and development expenditures, domestic credit, foreign direct investment inflow and corruption levels, do not seem to have a direct impact on it. This study makes a theoretical contribution to already existing literature by implementing the institutional development framework as one of the factors influencing the legitimation of start-ups. Moreover, it shows that some dimensions of institutional development positively affect the legitimation of start-ups.

Key Words:

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Preface

Probably everyone has been at least once asked the question “what do you want to be when you grow up or what do you want become”. Children’s answers are usually a police officer, a fireman or a princess, but as people grow older their perceptions on how they imagine their own lives change. So when they are asked the same question again later on, the answers are rather different. It can be argued that children’s visions have not changed over the past years, but the adults’ ones certainly have. Nowadays, as an alternative to answering the so-many-times-asked question, people often quote Tony Gaskins Jr. and his famous words: „If you don’t build your own dream, someone else will hire you to help build theirs”. Currently, people, instead of wanting to be teachers or scientists, want to become self-employed, they want to build their own empires, enter the path of unknown and unpredictable, to develop their own start-up, to build their own dreams.

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List of Tables and Figures

Table 4-1: Measures of Institutional Development ... 36

Table 4-2: Stepwise Regression on Amount of Capital ... 38

Table 4-3: Stepwise Regression on Number of Capital Providers ... 39

Table 4-4: Stepwise Regression on Reputation ... 39

Table 5-1: Descriptive Statistics and Correlation Matrix ... 42

Table 5-2: Collinearity Statistics Amount of Capital ... 43

Table 5-3: Collinearity Statistics Number of Capital Providers ... 43

Table 5-4: Collinearity Statistics Reputation of Capital Providers ... 44

Table 5-5: Regression on the Amount of Capital ... 46

Table 5-6: Regression on Number of Capital Providers ... 48

Table 5-7: Regression on Reputation of Capital Providers ... 49

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1 Introduction

Schumpeter (1934) was one of the first scholars to recognize entrepreneurs as a subject worth studying as their small and new businesses highly contribute to the economic growth and are essential for the healthiness of a country’s economic structures. Nowadays, their contribution not only in the economic but also in the management field of study is considered as obvious and inevitable for the economic and overall development of each country. Despite such valuable recognition of importance of these small and new businesses or so-called start-ups, they are yet still very hard to define. According to The Small Business Act, ‘a small business concern should be deemed to be one which is independently owned and operated and which is not dominant in its field of operation’ (U.S. Small Business Administration, 1978, p.121.1).

These young and small firms often struggle to survive compared to already existing and well-established firms and even more often fail and disappear. Stinchcombe (1965) argues that these statistics are a result of ineffective work roles and relationships and additionally due to the lack of connections with buyers and suppliers, or in other words start-ups are facing the liability of newness and smallness. The essential factors for survival are considered to be the stable relationships and sufficient resources (Baum, Calabrese & Silverman, 2000). Nevertheless, start-ups differ significantly in those terms and therefore these variations lead to different outcomes (Baum, 1996; Fichman & Levinthal, 1991). There is a consensus in the literature on the importance of the alliance network when accessing resources, stating that start-ups that have partnered up with a stronger player in the game, have a better access to the necessary resources (Gulati, 1998; Teece, 1992).

Recently, literature has focused on another aspect of start-ups and a way of gaining necessary access to fundamental resources through the legitimation of start-ups. Legitimation of start-ups, or how external audiences perceive and judge an organization, (Zimmerman & Zeit, 2002) has become without any doubt a critical and crucial asset of any start-up.

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Legitimation helps start-ups overcome the undesirable liability of newness and smallness, therefore raising the chance of survival and following growth (Stinchcombe, 1965).

The research on the legitimation has become very popular over just past few years, yet there is no full agreement on how and when start-ups gain and maintain legitimation, as many scholars refer to different theories or base their findings on divergent foundational assumption (Überbacher, 2014). Überbacher (2014), in his review of the legitimation literature, differentiates five different perspectives on the legitimation, including the institutional perspective. According to the institutional perspective, how external audiences perceive and react to ups is determined by the institutional environment in which start-ups operate.

The institutional environment is different from one country to another. Resource-based view and industry-Resource-based view have led scholars to explore the differences between industries, organizations and to what extent these difference are responsible for variations in the performance of different businesses (McGahan & Porter, 1997; Rumelt, 1991). As these differences have been acknowledged, the question of institutional differences has risen and led to an exploration of to what extent such differences matter (Henisz, 2000; Kostova & Zaheer, 1999; Miller & Eden, 2006; Rosenzweig & Singh, 1991; Westney, 1993; Zaheer, 1995). These studies proved that institutional environment does affect organizations’ activities and that no organization or business unit is immune to the institutional environment of the country in which it operates.

Research has long agreed on the importance of legitimation of start-ups as a necessary asset, and has become a popular topic among scholars (Überbacher, 2014). The literature on legitimation is extensive; however, most of the research focusing on the role of legitimation has not reached a consensus yet. When exploring and defining legitimation, scholars based their argumentations on different theories (Suchman, 1995), which later reflect their different

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findings. The vast majority of the previous literature has focused on external parameters that affect the legitimation of start-ups, such as on the influence of entrepreneurial identity on the legitimation of ups (Navis & Glynn, 2011) or on how the legitimation influences start-ups themselves, for instance the effect of legitimation on activities undertaken by start-up companies and on their survival rate (Delmar & Shane, 2004). In spite of scholars constantly expressing the importance of not only the legitimation for every business entity but also the significance of institutional environment in which those business units are embedded, they have so far failed to interconnect these two such outstanding factors determining the existence, activities, and other aspects of ‘everyday life’ of every business unit, including start-ups. Scholars, among others, Peng (2002) and Ghemawat (2001) stress the effects of institutional developments and their diversification among the countries, whereas academics such as Suchman (1995) and Zimmerman and Zeit (2002) emphasize the role of legitimation. Every business is exposed to a unique set of institutions that a particular country offers. Since the institutional developments vary across countries, their effect on the legitimation of businesses would vary as well. Therefore, legitimation is a factor to the survival of start-ups, which are exposed to different institutional contexts across countries. Accordingly, our research question is twofold:

(1) To what extent the economic and financial dimensions of institutional development influence the amount of capital invested in start-ups, and (2), to what extent the political

and social dimensions affect the number of capital providers and their reputation?

The purpose of this master thesis is to demonstrate the positive impact of the level of institutional development on the legitimation of start-ups. This argument is based on a long-known fact, that no firm is immune to its institutional surroundings. However, these

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surroundings differ within the world and thus create institutional differences or in other words different levels of institutional developments (Ghemawat, 2001). These variations among other factors are also behind the differences among firms’ performances (Makino, Isobe & Chan, 2004). Moreover, recent literature suggests that besides other factors that have an impact on the firms’ performances is the legitimation of start-ups. Legitimation affects a firm’s performance by providing a firm with the necessary resources such as financial capital, knowledge or customer awareness (Lounsbury & Glynn, 2001; Zimmerman & Zeit, 2002). As there is a proved positive relationship between a country’s level of institutional development and a firm’s performance and the legitimation of a firm and its performance, this study argues that there is also a positive relationship between the institutional development and the legitimation, that can be applied not only to already well-established business units, but also to new and small companies, such as start-ups.

We test our hypotheses linking the institutional development and the legitimation of start-ups for a sample of 261 start-up companies from 24 different countries. All of the companies included in the sample were established after year 2009, thus the potential bias caused by the recent financial crises would be eliminated. The assumed positive effect of economic, financial, political and social dimensions of institutional development on the amount of capital invested in start-ups, number of capital providers funding start-ups and their reputation will be therefore tested. Our findings suggest that there is a partial positive effect of economic and social dimensions on the legitimation of start-ups as well as fully established positive influence of the political dimension. On the contrary, financial dimension seems to have no impact on the legitimation of start-ups.

Our contribution is twofold: first, by incorporating the aggregated effect of institutional development on the legitimation of start-ups, we add to the current literature by implementing the institutional development framework within the influents of the

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legitimation of start-ups. More specifically, we connect the economic and financial dimensions of institutional development to the amount of capital provided to start-ups and political and social dimensions to the number of capital providers and their reputation, all of which have been broadly accepted as signs of legitimation. Second, by distinguishing between different dimensions of the institutional development and their effects on various forms of perceived legitimation, we show that there is a theoretical ground for assuming positive relationships between dimensions of institutional development and the legitimation of start-ups. In practical matter, this thesis makes a contribution on managerial level, where it shows how institutional development influences the capital inflow into start-ups as well as how many capital providers are willing to invest under certain institutional circumstances and thus helps entrepreneurs with gaining the legitimation for their businesses. Additionally, from a capital provider’s point of view, this study can be used as a base for acknowledging whether and how the institutional environment affects their reputation and consequently adding this predictor into the parameters they consider when making investments.

This thesis is going to analyze the relationship between the different dimensions of institutional development and the legitimation of start-ups. The following section will provide a closer look at the existing literature on start-ups, legitimation and institutional development. Later, the theoretical framework and proposed hypotheses will be introduced and further explained. Subsequently, the hypotheses will be tested among 261 companies within 24 different countries using a linear regression analysis. Lastly, all the outcomes will be discussed and elaborated on in the discussion part.

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2 Literature Review

To depict a relationship between the institutional development and the legitimation of start-ups, a clear understanding of each term is needed. The following section explains every term in depth and furthermore it sets ground for their interconnections which are later discussed within the theoretical framework.

2.1 Start-ups

Start-ups have become quite popular in recent years, but as it has been mentioned earlier defining a start-up is not an easy task. According to Scott and Bruce (1987), there are several requirements in order to call a start-up a start-up. Capital should be provided and ownership held by an individual or a small group, employees and owners should be focused in one geographic area, but not necessarily the markets in which the start-up operates and the management of a start-up should be independent and managers are often the owners. It has been long proved that start-ups and small businesses are essential for healthy economies (Swain, 1995) and that they play an important role in the business world.

Start-ups vary greatly in what industry they operate, which geographic area they are focused on, in the level of their internationalization and other attributes such as managerial educational background or form of a legal entity. Oviatt and McDougall (2005) defined four types of start-ups based on the coordination of value chain activities and number of countries they are involved in. Firstly, start-ups that operate in only a few countries and have a low degree of value chain activities are called export or import start-ups. Secondly, multinational traders similarly operate in a few countries, but in comparison to import/export start-ups their degree of value chain activities is higher. These start-ups are able to take advantage of imbalances of resources among different countries and to create markets where they have not existed before. Thirdly, geographically-focused start-ups operate within the range of only a

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few countries but the level of value chain activities is significantly high. They derive their competitive advantage from serving particular needs of a certain geographic region. And lastly, the global start-ups are from their inception involved in many activities spread across many countries. Although, developing a global start-up is a difficult task, once it is well-established, it possesses the biggest competitive advantage, i.e. „a combination of historically unique, causally ambiguous, and socially complex inimitability with close network alliances in multiple countries” (Oviatt & McDougall, 2005, p. 38)

During the initiation period of a start-up, it might seem that developing a unique and perspective idea for it would be the biggest challenge, but as entrepreneurs progress, they will face even more difficult tasks and that is how to sustain their own businesses and how to stay viable in such a rigorous competitive world. Zimmerman and Zeit (2002) confirm the difficulty by stating that 40 percent of start-ups fail in the first two years of their existence. The question what the differentiator is between the successful ones and those that disband after a certain period of time has been a focus of research for a while now. Many researchers find the answer to the survival question in financing strategies, creative characteristics of the founders or their personal traits. These can be seen as internal factors influencing the success of the start-ups. However, recently there has been a lot of attention to another internal factor- legitimation, which is externally created and perceived by the start-ups’ audiences. Legitimation has received a significant amount of attention in past few years as a key factor determining the growth and survival of start-ups.

2.2 Legitimation of Start-ups

According to Suchman (1995), legitimation is defined as „a generalized perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions“(Suchman, 1995, p.574).

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In other words, legitimation can be seen as an acceptance of a company by its surrounding environment. Starr and MacMillan (1990) go as far as stating that legitimation is a required component for start-ups and new ventures’ success. Zimmerman and Zeit (2002) see legitimation as a resource that is just as necessary as other forms of assets, e.g. capital, technology, personnel, customer goodwill and networks.

Churchill and Lewis (1983) in their work identify five stages of growth of small business. According to their work, in the first phase called the existence, the main concern of the founders is how a start-up will obtain customers. The second stage, known as survival, deals with the question of how to generate cash flow and how to sustain the business. Yet, start-ups and new ventures represent a high uncertainty compared to well-matured firms, they lack the experience and may be perceived as threats to their potential customers and investors due to their novelty and small size, which taken together results in the liability of newness and smallness (Bhidé, 2000; Kale & Arditi, 1998; Aldrich & Fiol, 1994; Stinchcombe, 1965). Start-ups and new ventures therefore often lack the resources they need for their growth and survival. Legitimation is often seen as a key solution to such liabilities (Zimmerman & Zeit, 2002; Stinchcombe, 1965) and moreover, legitimation helps start-ups and new ventures with accessing the necessary resources, whether financial or personnel and thus becoming a sustainable business (Aldrich and Fiol, 1994; Lounsbury and Glynn, 2001; Zimmerman and Zeitz, 2002).

Drori et al (2009) describe two types of legitimation, internal and external. The former is „critical for motivating actors to construct a sufﬁciently robust nascent organizational culture and to enhance creative activity”, while the latter is necessary in order to acquire the resources and customers (Drori et al, 2009, p.734). Research suggests that internal and external legitimations are less likely to be independent and more likely to be interdependent (Rao, Chandy & Prabhu 2008). Start-ups and new ventures can achieve internal legitimation

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through four types of actions, namely market, scientific, locational, and historical (Lu & Xu, 2006), while external legitimation can be achieved by creating strategic alliances with already well-established external players (Rao, Chandy & Prabhu, 2008). Although, the importance of legitimation has been highly recognized over the past couple of years, it is still quite not sure how organizations can achieve it.

Another way of acquiring external legitimation is via institutional isomorphism. It should not be forgotten that organizations operating in a certain type of environment are exposed to that particular institutional context. According to institutional theory, organizations can gain legitimation through several institutional mechanisms that resemble established cultural and constitutive belief systems (Meyer & Rowan, 1977; DiMaggio & Powell, 1983; Zucker, 1987; Drori et. al, 2009). Institutional pressures, such as organizations are advised to use certain mechanisms or producers for instance, can ‘force’ start-ups to comply with these pressures and thus unintentionally become isomorphic with other already existing organizations. Hence, such isomorphism can lead to the wishful legitimation.

Überbacher (2014) in his paper reviewed already existing literature on the legitimation and classified five different perspective on legitimation of start-ups, namely institutional, cultural, ecological, impression management and social. The institutional perspective stresses the influence of institutions on the legitimation of start-ups and how the external audiences perceive it. These studies most often describe the effects of two types of institutions, cognitive and evaluative. Cognitive institutions represent beliefs and customs which a certain audience within a particular organizational unit considers as normal and accepted (Meyer & Rowan, 1977) and they include beliefs such as e.g. entrepreneurs possess a certain educational background (Cohen & Dean, 2005). External audiences observe organizations complying with such beliefs and customs as legitimate and thus those organization are more likely to access necessary resources. Evaluative institutions, on the other hand, constitute of

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authoritative institutional organizations with power to punish, such as governmental or financial organizations. The trust of external audiences in start-ups often depends on the evaluative organizations as they are seen as reliable authorities and they help with making investment decisions. On the other hand, the cultural entrepreneurship perspective on the legitimation of start-ups puts emphasis on the cultural agency as a mechanism of legitimation, which is defined as „actor’s capability to innovate upon received cultural categories and conditions of action in accordance with their personal and collective ideals, interests, and commitments” (Emirbayer & Goodwin, 1994, p. 1442). The ecological perspective claims that legitimation of start-ups is implied by its market industry, also known as structural context. Hannan et al. 2007 argue that external audiences create a scheme for already existing and well-established industry and when a start-up enters such environment, it automatically becomes legitimized due to known schemes and vice versa. The impression management perspective pays attention to impression management tactics which are used by entrepreneurs within the business start-ups. Entrepreneurs emphasize business characteristics that are favorable for the legitimation and conversely hide those that are not (Elsbach, 2003). On the contrary, the social movement perspective describes how start-ups gain legitimation through social mobilization (Rao, 2004; Weber et al., 2008). Social movements represent informal united actions that focus on ethical, political and social problems and are aiming to improve and solve such problems (Davis et al., 2008). Moreover, it includes collective framing activities such as strikes that are organized in order to gain legitimation for new business activities (Benford & Snow, 2000).

All the above mentioned perspectives share three common assumptions about the external audiences, purpose of the legitimation and the consequences of legitimation. Firstly, all of them agree on the role of the external audiences as judges of the legitimation of start-ups. Secondly, the main purpose of the legitimation is to gain and retain legitimation.

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However, all the perspectives seem to pay extra attention to how start-ups gain legitimation since they are believed to lack it due to their newness (Driori et al., 2009). And lastly, the consequences of legitimation shows positive influence on the performance and survival rates. In other words, legitimation helps start-ups to overcome the liability of newness (Stinchcombe, 1965) and therefore gain access to necessary financial, human, and other resources.

Although, there is no consensus on how to measure the level of legitimation, for the purposes of this thesis the following variables will be used: the reputation of capital providers, the amount of capital invested, number of capital providers and the reputation of capital providers (Chang, 2004).

2.3 Institutional Development

According to North (1990), institutions represent restrains created by humans to shape the behavior and interactions among individuals within a given community, while Scott (1995) defines them as “cognitive, normative, and regulative structures and activities that provide stability and meaning to social behavior” (Scott 1995, p. 33). Both definitions state that institutions can be seen as rules of the game, either formal or informal, and as pillars of the economic, financial, political and social relations within a society (North, 1990; Scott, 1995). Every company, whether a small one or a big one, or a well-established one or a start-up, operates in a certain institutional environment in which it is embedded and therefore there is no doubt that institutions as a matter of fact do matter (Peng, 2002). Institutional development has been recognized as an important factor of an overall development of countries and is defined as „the extent to which the economic, political and social institutions in a country are developed and are favorable“(Chan, Isobe & Makino, 2008, p. 1179). Thus, it can be argued

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that every organization is exposed to certain economic, political, social and financial dimension of institutional environment which will be further discussed into details.

Economic Dimension of Institutional Environment

Economic institutions generally involve market intermediaries, which include agents such as bankers, auditors, consultants, brokers, traders and dealers. These market intermediaries are there to govern the stimulus for and impediments of economic actors (North, 1990). They deliver credible information between parties that are involved in the economic transactions and help to reduce the information problem and therefore enhance the transparency of the transactions (Akerlof, 1970; Diamond, 1984; Khanna & Palepu, 1997; Khanna & Rivkin, 2001). However, when market exchange lacks or has insufficient intermediaries, the organizations may find it too expensive to raise capital, to acquire necessary resources and to find competent professional intermediary services (Khanna & Palepu, 2000).

Economic institutions also include the suppliers of the infrastructure in either physical, human or technological form, which help with supporting economic transactions. Physical infrastructure includes the basic facilities, services and installations that are essential for a properly functioning economy, human infrastructure represents skilled labor and networks that help organizations with acquiring needed knowledge and expertise (Saxenian, 1994; Teece, 1986) and technological infrastructure is the ground base for the technological development which provides organizations with competitive advantage.

Financial Dimension of Institutional Environment

Financial institutions are institutions whose purpose is to mediate financial resources between two parties or in other words they work as financial intermediaries. The primary job of economies is to guarantee that financial capital is allocated efficiently. In order to achieve

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such effectiveness, financial capital should be invested where the returns on capital are expected to be high and vice versa (Wugler, 2000). Schumpeter’s (1912) idea that a well-functioning financial system is mandatory for a good economy is nowadays considered as a basic one (Miller, 1998). According to Siklos (2001) there are three major types of financial institutions, i.e. depositary institutions, contractual institutions and investment institutions. Depositary institutions include institutions that accept and manage deposits and provide loans, institutions such as banks, trust companies, credit unions, etc. Contractual institutions include institutions of insurance and pension funds while investment institutions cover investment banks or brokerage firms.

Financial institutions are highly regulated as they are part of a country’s economy. Such regulations include prudential regulation, consumer protection and market stability. Regulatory agents differ across countries and can be either in a form of one common agency for all financial institutions or they can be separated agencies for different types of financial institutions such as banks, trust companies or pension funds.

Political Dimension of Institutional Environment

Political institutions are systems of politics and governments that develop, enforce and implement constraints on the key local and foreign political actors. They create policies that can enhance the international trade by providing foreign organization with attractive investment stimuli, such as subsidizes, protection rights or competitive advantages. On the other hand, they can also discourage international exchange by imposing e.g. entry barriers or favorable regulations for local organizations (Chan, Isobe & Makino, 2008).

Moreover, political institutions do not only impose constraints on the key political actors but they also execute law (Rodriguez, Uhlenbruck & Eden, 2005). The inefficient application of laws, resulting in poor protection of property rights and corruptions,

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discourages organizations from engaging in innovative activities (North, 1990) and instead makes them occupy themselves with political activities (Boddewyn & Brewer, 1994).

Social Dimension of Institutional Environment

Social institutions represent practices that are mutually shared and accepted by a society and the appropriateness of behavior of members of a society can be evaluated against them (Chatman & Cha, 2000). Social norms are often invisible to the eye of an observer. These norms are another factor that generates differences among countries and therefore social institutions perform a role of a union, i.e. they provide a guidance for all the players within a given economy.

Institutions are diverse due to the dissimilar practices of social institutions and result in different work ethics, work attitudes, trust and productivity all of which have an impact on the cost of doing business (Chan, Isobe & Makino, 2008). La Porta, Lopez-de-Silanes, Sheifer and Vishny (1997) found that high level of trust among the society members is positively related to economic performance. Conversely, social conflicts can lessen the business operations as lower the efficiency of international economic activities (Ghemawat, 2001).

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3 Theoretical Framework

Legitimation translates into an acceptance of a business entity by an external audience within a given environment (Suchman, 1995). The external audience within a particular environment decides whether the business entity and its activities are aligned with what a given audience considers acceptable and thus whether the business entity is legitimate (Suchman, 1995). Players that have already been a part of legitimized institutional environment develop their own sets of rules or preferred organizational forms, both of which are consequently passed on the newly entering players. These favorable and accepted rules and organizational forms create a mimetic isomorphic pressure and new business entities tend to comply with them in order to gain legitimation as a crucial resource (DiMaggio & Powell, 1983; Scott, 1995). New business entities, including start-ups, incline to comply with mimetic isomorphic pressure, especially in uncertain situations and institutional environments to which they are exposed in the beginnings of their existence (Henisz & Delios, 2001; Chan & Makino, 2002). However, imitating other already legitimized business entities is not the only way of how to obtain legitimation for themselves. Another possible way of gaining it is by creating an alliance with well-established and matured organizations, e.g. offering a number of stakes in a firm for a specific amount of funds. Start-ups tend to lack not only resources but also information on how to achieve legitimation in the particular environment and thus establishing a partnership with other players may supply what start-ups in such situations need (Koopmans, 1957; Sutcliffe & Zaheer, 1998; Kostova & Zaheer, 1999). Strategic alliances demonstrate the approval by other organizations within a particular environment and prove that the new business entity is valuable for the local environment (Dobrev, 2001; Chang, 2004).

The development of institutions differs significantly across countries (Ghemawat, 2001; Kostova & Zaheer, 1999; Miller & Eden, 2006; Rosenzweig & Singh, 1991; Westney,

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1993; Zaheer, 1995) where the level of institutional development is comparably lower in developing countries than in developed countries due to the absence of or poor execution of institutional rules (North, 1990). Start-ups not only have to deal with various institutional developments but also with each country’s unique legitimizing players (Westney, 1993; Kostova & Zaheer, 1999). In some institutional environments, political institutions, such as governments that introduce legal restrains and create rules which all the organizations have to play by, are the strongest legitimizing players (Dunning, 1988) while countries where political institutions are not considered as the most legitimized entities, other actors take on the legitimizing role, e.g. labor unions or supplier groups (Westney, 1993; Kostova & Zaheer, 1999). „ A lack of reliable market information, efficient intermediary institutions, predictable government actions and an efficient bureaucracy creates what are known as institutional voids“ (Chan, Isobe & Makino, 2008, p. 1182) and such voids result in costly transaction markets because institutions do not hold the cognitive and moral basis for legitimation (Henisz & Zelner, 2005). Transaction costs arise as organizations need to protect their assets, transformation costs increase because a low level of institutional development is perceived as a higher risk of contracts that will not be enforceable and efficiency and competitiveness of organizations decreases due to use of inferior technology which is a result of insecure property rights (North, 1990).

Chen (1999) states that efficient markets and efficient institutions are positively related to the easiness of obtaining the financial capital and therefore when such institutions are missing, the inadequate financial sources may cause the dispute of organizations. Firms can obtain capital either through formal or informal channels, where the former refers to financial capital provided by personal and non-contractual agreements (Granovetter, 1985) and the latter refers to the financial capital acquired through political, judiciary, legal and economic relationships. Li and Ferreira (2011) argue that a low level of institutional

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development pushes organizations towards gaining the financial capital through the informal channels. They state that the formal business exchanges are better supported by well-developed institutions that promote regulatory effectiveness which leads to the use of formal channels over the informal channels. As it has been mentioned earlier, according to North (1990), governments have incentives to stimulate trade through policies that can have either positive effects on economic activity or can create inefficient support system (Doh, 2000). Moreover, governments possess a significant influence on the development and sustainability of institutions that administrate economic activity. Peng and Heath (1996) found that the higher the interventions by the government, the higher the chance that the organizations will try to avoid governmental contractual agreements. Therefore, the interventions made by the government are seen rather as an impediment to the use of informal channels for obtaining financial capital. Moreover, Peng (2001) suggests that the level of development of both formal and informal market-supporting institutions boosts the wave of entrepreneurship. Higher level of institutional development can translate into an acceptance of organizations and their activities by external audiences and coerce organizations’ intentions “as the consequences of the institutions are beyond normative evaluation as a result of having attained legitimation” (Chan, Isobe & Makino, 2008, p. 1184).

The following sections develop and elaborate on eight proposed hypotheses (see figure 3-1) concerning the relationships between different dimensions of institutional development and different factors determining the legitimation of start-ups.

3.1 Institutional Development and Amount of Capital

Access to financial capital is one of the key factors for growth and survival of organizations and start-ups (Churchill & Lewis, 1983). Chang (2004) argues that start-ups often lacking necessary legitimation in order to gain the needed resources, are likely to gain more positive

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public attention by partnering up with other already legitimized organizations. Such partnering often takes place in the form of a sponsorship, i.e. by providing financial capital. Banks are the essential sources of legitimation in developing countries as banks in developing economies tend to involve in financial transactions with over-indebted state-owned enterprises (Li and Ferreira, 2011). Organizations then incline to engage in informal relationships or relationships with illegitimate mechanism (Newman, 2000). Thus, if the level of development of financial system is low, the organizations are likely to look for funding among informal channels of financial sources.

Economic and financial development represent strong proxies for quantifying the health of an economy. They have an influence on everyone and everything within an economy, including start-ups, and their capital providers (Samila & Sorenson, 2011). They affect companies’ profits, stock markets, they determine the amount and the flow of the capital within an economy. Ghemawat (2001) shows that an economic factor that creates the biggest differences among countries is the indicator of wealth. Wealth of countries, which is most often determined by GDP per capita, predicts countries’ volumes of trade and with which other countries they get involved. Since countries can be seen as individual business units, the same pattern applies to any other business entity including matured firms as well as start-up companies. Therefore, it can be said, the healthier and wealthier the economy and the more developed economic and financial institutions, the more investments into companies made by capital providers it attracts.

Similarly, Konchitchki and Patatoukas (2014) say that the gross domestic product is the most vital determinant of a country’s growth and a factor that determines the investment decisions. Thus, investors seeking high profits prefer to invest in countries that exhibit higher GDP per capita throughout the years. Moreover, Gomper and Lerner (1999) find that R&D expenditures have a positive effect on venture capital investments, while England (1998)

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states that leading economic scholars and macroeconomists eagerly refer to data on real GDP per capita as a source that can provide insights into standards of living and economic progress. The domestic product, as one of the indicators of development of financial institutions, provides information about capital flows from banks and other institutions to business and vice versa within an economy. Investments made by banks or other financial organizations are essential to economic growth. Economic growth, thus, appeals to an even higher number of investments with more intense volumes flowing not only within one country’s economy (World Bank, 2015). Consequently, the more attractive the economy is, the more attention it gets from foreign investors as well. Borenzstein, De Gregorio and Lee (1998) confirm that economic growth positively influences firms’ performances and thus generates a cycle of higher foreign direct investments inflow. Summarizing all the above, the following hypotheses have been developed:

H1a: The gross domestic product of a country has a positive influence on the amount of capital that is invested in start-ups originating in the country.

H1b: Research and development expenditures financed by a country have a positive effect on the amount of capital that is invested in start-ups originating in the country.

H1c: The domestic credit of a country has a positive impact on the amount of capital that is invested in start-ups originating in the country.

H1d: Foreign direct investment inflows have a positive influence on the amount of capital that is invested in start-ups originating in the country.

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3.2 Institutional Development and Number of Capital Providers

Political systems play an important role in business environments as well due to the enforceability of contracts. Ineffective legal systems that fail to organize and oversee financial transactions may make a room for organizations pursuing the informal relationships that rely on social sanctions among the parties involved in the transactions themselves (Coleman, 1988). However, informal organizations can take advantage of such transactions and feasibly seek private arbitration mechanism (Li & Ferreira, 2011). Peng and Heath (1996) found that the higher the interventions by the government, the higher the chance that the organizations will try to avoid governmental contractual agreements. Therefore, the strong interventions made by the government are seen rather as an impediment to the use of informal channels for obtaining financial capital.

Yet, this does not mean that there is no need for interventions. Political institutions reduce the risk that accompanies all financial transactions and they provide incentives in forms such as subsidies or permissions to invest (Bodewyn and Brewer, 1994). Capital providers see these incentives as strong advantages when comparing which countries are more attractive as well as one of the determinants when and if making investments (Chan, Isobe & Makino, 2008). Capital providers that are willing to invest in start-ups that are from their nature instable and unknown, and thus they tend to lean on the institutions and their power to influence what start-ups cannot. Similarly, social institutions play an important role where social background and behavior differs from the one that is known and understood (Martin, 2004). These types of behaviors vary not only between countries but also among different institutions within one country. Social institutions ensure that these behaviors do not collide by providing sets or rules, such as legal rights, that are applicable to everyone in the same manner. Capital providers are thus protected in the same way and possess the same

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legal rights as other players within a given economy, which positively affects their decisions when making investments (Ghemawat, 2001).

Park and Ginarte (1997) argue that the strong protection of intellectual property rights and strong legal rights alongside with their effective enforcement bring more capital investors into an economy. Intellectual property rights provide protection of valuable assets, while legal rights provide security for investor themselves. Moreover, Zambujal-Oliveira and Pinhero-Alves (2010) found that the easiness of doing business attracts investors more than when a country creates impediments towards new players that would be eager to deliver financial resources into companies. Based on these arguments, the following hypotheses were depicted:

H2a: The strength of intellectual property rights in a country is positively related to the number of capital providers that will invest in start-ups originating in the country.

H2b: The level of easiness of doing business in a country positively influences the number of capital providers that will invest in start-ups originating in the country.

H2c: The strength of legal rights in a country positively affects the number of capital providers that will invest in start-ups originating in the country.

3.3 Institutional Development and Reputation of Capital Providers

Corruption, as one of the variables determining the level of institutional development, increases the costs of financial transactions between organizations and formal institutions and hence, pressures organizations to seek alternatives in form of informal channels. Peng and Luo (2000) found that corruption often takes place in transition economies and moreover

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Dixon and Polyakov (1998) state that the corruption in Soviet political system reached every level of economic and social activity. Additional costs that arise with the need of a bribery force organizations to either rely more on the informal channels of funding or establishment in countries with lower corruption levels.

Moreover, organizations attain and retain different statuses and reputations. Organizations that operate in a reliable, accountable and trustworthy environment have better chances of survival and better performance rates (Stuart et al., 1999). Williamson (1985) state that dodging organizations may also lose their reputation, which often leads to the decrease of economic transactions because trust is considered as one of the main factors for encouraging social interactions and relationships (Moore, 1994).

Stuart et al. (1999) also found that organizations that partner with well-established allies with high legitimation tend to be more profitable than ones without such connections. It can be therefore argued that high legitimation of alliance partners have a positive impact on the legitimation of given organizations. According to Chang (2004), high legitimation signals better reputation, lower corruption rates and thus higher level of institutional development and vice versa. Thus, the following hypothesis is proposed:

H3: The corruption level in a country negatively influences the perceived reputation of capital providers investing in start-ups originating in the country.

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Figure 3-1: Theoretical Framework CPI SLR EDB IPR FDI DC R&D GDP

Amount of

Capital

Number of

Capital

Providers

Reputation of

Capital

Providers

H1a H1b _H1c _H1d H2a H2b H2c _H3

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4 Data and Method

This section is dedicated to the methodological part of the thesis. Firstly, the way the data was obtained and the sources used will be described. Secondly, the variables used in this research will be presented and finally, the data analysis that was conducted including regression models will be explained.

4.1 Sample and Data Collection

The company data was retrieved from the Orbis database, which possesses a collection of around 150 million companies worldwide with special attention to the private companies’ information. In order to choose from such a large pool of companies, the following criteria were used: companies with active status (default of payment), companies with at least one shareholder and known number of shareholders, companies incorporated after 2009 in order to overcome a possible bias of a 2008 financial crisis and all companies categorized as small with less than 15 employees, operation revenue up to one million euros and with total assets up to two million euros. The combination of these criteria reduced our sample to 455 companies. The majority of the companies (over 90%) were established in year 2013, therefore in order to avoid any changes in institutional development that could affect the results, we decided to focus solely on companies founded in that particular year. However, more companies had to be later excluded due to missing data leaving us with the final number of 261 companies.

Nonetheless, 261 companies represent a data set extensive enough to run statistical tests with a valid number of observations.

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4.2 Measurements

4.2.1 Dependent Variables

This study consists of one dependent variable - the legitimation of start-ups. Past studies have depended on measuring legitimation through code adoption, organizational linkages, and media perception (Schneiberg & Clemens, 2006). However, scholars argue that these measures can be biased since code adoption and alignments of organizational linkages can reflect pure symbolic routine (Westphal & Zajac, 1994) or indicate ties to prominent institutional players (Baum & Oliver, 1992), respectively. Therefore, this master thesis will follow the study of Chang (2004) and will measure the legitimation through the amount of capital invested in start-ups, the number of capital providers and the reputation of capital providers.

4.2.1.1 Amount of Capital

For hypotheses H1a to H1d the dependent variable is the amount of capital invested in start-ups during their first year of existence. The amount of capital will be measured by the volume of shareholder funds in total from all the shareholders of each start-up. The data on shareholder funds was provided by and collected from the Orbis database.

4.2.1.2 Number of Capital Providers

Hypotheses’ H2a to H2c dependent variable is a number of capital providers that have invested in each start-up. The number is expressed by a number of all shareholders participating in financing an individual start-up. This number was retrieved from the Orbis database as well.

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4.2.1.3 Reputation of Capital Providers

The dependent variable of the last hypothesis H3 is the reputation of capital providers in a country of start-ups origin, which is stated in a number of articles written about each shareholder during the year of start-ups establishment, i.e. year 2013. The number was obtained from Google News website, specifying the period between 1st of January, 2013 and 31st of December, 2013 and location as a country where a start-up has been established. Google News website provided us with search throughout every online newspaper within the particular country. Since legitimation is defined as a perception of appropriateness of external audience on a company and since the media both mirror and shape perceptions, this measure seems appropriate to capture legitimation in its most common sense (Pollock & Rindova, 2003)

4.2.2 Independent Variables

This research has eight independent variables, all measuring the level of institutional development of countries where start-ups from our data set have been founded. Following the work of Chan, Isobe & Makino (2008), institutional development framework was divided into four dimensions, namely economic, financial, political and social.

4.2.2.1 Economic Dimension

The level of development of economic institutions is measured by the gross domestic product (GDP) per capita and research and development expenditures (R&D) as a percentage of a country’s GDP (England, 1998). According to Guellec and Van Pottelsberghe de la Potterie (2004), R&D expenditures tend to have a positive effect on a country’s advance and therefore are a suitable proxy for measuring the institutional development.

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4.2.2.2 Financial Dimension

The development of financial institutions consists of two variables, domestic credit (DC) provided by the financial sector and foreign direct investment (FDI) inflow respectively. The former is measured as a percentage of a country’s GDP taking into account all the available information from monetary authorities, deposit banks and other financial corporations, e.g. finance and leasing companies, money lenders, insurance corporations, pension funds and foreign exchange companies (Lane & McQuade, 2014), whereas the latter is a sum of equity capital, reinvestment of earnings and other long-term and short-term capital divided by a country’s GDP. Studies of several scholars, including Estrin and Meyer (2004) prove that FDI positively relates to the improvement of formal institutions.

4.2.2.3 Political Dimension

The political dimension of institutional development is quantified by the intellectual property rights (IPR) index and the ease of doing business (EDB). IPR are key determinants of economic growth since poor protection discourages companies from competitive operations (North, 1990) and the IPR index presents the comparison among countries to what extent the patents and property rights are enforced. The EDB ranks the regulatory environments according to their favorableness of starting and operating a business and sorts their distance to frontier scores, where frontier represents the most favorable environment of all (Caves, 1996; Dunning, 1998; Blonigen, 2005).

4.2.2.4 Social dimension

Social institutions are expressed by the strength of legal rights (SLR) index and the corruption perception (CPI) index. The SRL measures to what extent the collateral and bankruptcy laws protect the rights of borrowers and lenders and hence embrace the lending, while CPI determines the perceived level of corruption through experts assessments and opinion surveys (Jerbashian & Kochanova, 2015). Cuervo-Cazurra (2008) state that the level

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of corruption has a significant impact on uncertainty and costs of doing business in a particular country and a spread of it can support political behavior (Boddewyn, 1988; Bodewyn & Brewer, 1994) and thus it is a weighty variable.

Table 4-1 shows each dimension and its variables and the sources from which the data was obtained.

Table 4-1: Measures of Institutional Development

Dimension Variable Source

Economic GDP International Monetary Fund R&D OECD/ World Bank Group Financial DC World Bank Group

FDI World Bank Group

Political IPR International Property Rights Index EDB World Bank Group

Social SLR World Bank Group

CPI Transparency International

4.2.3 Control Variables

Studying the influence of institutional development on the legitimation of start-ups requires a control for several variables on three different levels, the industry level, firm level and country level specifically. Each of these levels is measured by variables that are being elaborate on later in a following section.

4.2.3.1 Industry-level Variable

The type of industry strongly influences the amount of the capital that needs to be and is being invested in a start-up as some industries require more funds into assets such as land or bulky engines. Additionally, some industries are more knowledge intensive than others and

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therefore, it is necessary to control those (Coombs & Gilley, 2005). Our dataset consists of three different types of industries classified according to NACE- the European industry standard classification system consisting of four digits. The industries were the following: production and goods (industry 1), services (industry 2), and financial activities (industry 3), Companies have been coded into dummy variables as 1 if they belonged to the industry and 0 if they did not (Hillman & Keim, 2001).

4.2.3.2 Firm-level Variable

As a firm-level control variable a size of the firm was used and it was measured by its return on assets (ROA). The size of a firm has a generally significant impact on the amount of the capital and number of shareholders, as smaller firms often require smaller amounts of capital and therefore less shareholders providing the capital (Lincoln, Gerlach & Ahmadjian, 1996). The data on ROA was retrieved from the Orbis database.

4.2.3.3 Country-level Variable

The level of inflation was chosen as a country-level variable due to its heavy impact on financial situation of countries. High levels of inflation have a known negative effect on the development of countries and thus on thus financial performances and therefore on the amount of capital flows. The data about inflation was obtained from the OECD data library for countries where the start-ups were established for year 2013.

4.3 Method and Model Specification

The proposed hypotheses are tested through a regression analysis, which is used when one or more independent variables are assumed to have an influence on one dependent variable. The best straight line through sets of variables is created by the regression analysis and such an association can be expressed in the following formula:

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Y = β0 + β1 * X1i + β2 * X2i + β3 * X3i + … + βn * Xni + ε

Parameters β0 and β1,2,3,n are the regression coefficients, where β0 stands for the intercept and

β1,2,3,n for the slope of the straight line which creates the relationship to X1i,2i,3i,ni. The slope

represents the change by one unit in the dependent variable as a result of a change by one unit in the independent variable. The ε stands for the error that describes the difference between assumed X1i and the actual X1i (Field, 2009).

To test the stated theoretical framework, three different linear regressions are conducted. First a simple regression is used to test the relationship between the amount of capital and the level of institutional development. This regression was tested for six models (see table 4-2), which were organized in hierarchical order. The first model tests the relationship between the amount of capital and industry dummy variables, inflation and ROA as control variables. The second, third, fourth and fifth model tests the relationship adding one independent variable at the time, GDP, R&D, DC and FDI respectively. The last- sixth model includes all the variables together.

Table 4-2: Stepwise Regression on Amount of Capital

Model Control Variable Independent Variable

Industry Inflation ROA GDP R&D DC FDI

Model 1 X X X Model 2 X X X X Model 3 X X X X Model 4 X X X X Model 5 X X X X Model 6 X X X X X X X

The second regression (see table 4-3) consists of five models, all of which are using the number of capital providers as a dependent variable. The first model analyzes the relationship between the number of capital providers and all the control variables in the same

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way as the first regression. The second, third and fourth model adds on one independent variable individually. While the second model uses the dependent variable, control variables and IPR, the third one is composed of DV, CVs and EDB and the fourth model substitutes IPR and EDB with SLR.

Table 4-3: Stepwise Regression on Number of Capital Providers

Model Control Variable Independent

Variable

Industry Inflation ROA IPR EDB SLR

Model 1 X X X

Model 2 X X X X

Model 3 X X X X

Model 4 X X X X

Model 5 X X X X X X

The last, third, regression is used to describe the relationship between the last dependent variable, i.e. the reputation of capital providers and the last independent variable, i.e. corruption perception index (see table 4-4). This regression involves two models. The first model, following the structure of two previous regressions, includes the dependent variable and all control variables. The second and final model adds the CPI as an independent variable.

Table 4-4: Stepwise Regression on Reputation

Model Control Variable IV

Industry Inflation ROA CPI

Model 1 X X X

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5 Data Analysis and Results

This section of the thesis focuses on the outcomes found after running the analysis. Firstly, the descriptive part analysis is presented and secondly the statistical analysis is elaborated on.

5.1 Descriptive Analysis

The descriptive analysis of dependent, independent and control variables (see table 5-1) provided us with the following results. Institutional development as well as companies varied significantly as it can be seen in table 3 which provides us with the means, standard deviations and correlations. The GDP varied considerably with a mean of $ 28,635.857 and standard deviation of $ 23,926.659. The same applies to R&D, CPI, SLR, DC and FDI variables, which means that the countries of origins of companies that participated in the research have different levels of institutional development, allowing us to test a greater spectrum of institutional development levels and their effect on the legitimation of start-ups.

Similar pattern can be seen within the dependent variables as well, as the spread of data was large, e.g. the mean of reputation was 27.766 and its standard deviation was 363.103. These results tell us that the companies used for this study vary greatly in terms of their legitimation and therefore can give us better understanding of how our independent variables affect it.

Within 261 companies, 10.3% belonged to industry 1- goods and production activities, 60.2% belonged to industry 2- services, and 29.5% belonged to industry 3- financial activities. ROA as a control variable with a mean of $ -1,761 diversified extremely with standard deviation of $ 25,360, which indicates that participating companies are not doing very well financially, which can be often observed in start-ups’ performance in the first years of existing.

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Inflation, similarly, fluctuates notably around the mean of 2.5 % with a standard deviation of 1.815%. This standard deviations suggests that start-ups’ countries of origins perform quite differently when it comes to inflation and therefore it is necessary to control for it.

5.2 Statistical Analysis

5.2.1 Correlation Analysis

Table 5-1 summarizes the correlations between the dependent and independent variables. According to this correlation matrix, several significant correlations can be seen and the most notable ones will be discussed further.

GDP has significant positive correlations with several variables, such as R&D, IPR, EDB, and CPI. Surprisingly, there is a negative correlation with SLR and FDI, which gives the ground for further investigation using the regression analysis. In addition, R&D correlates considerably with IPR and CPI. IPR, similarly, shows high correlations with EDB, CPI, and DC. EDB correlates strongly with CPI, while CPI correlates sizably with DC. SLR shows more negative correlations besides the one with GDP, R&D, IPR, CPI, FDI and DC namely, where the most significant one is with DC. DC has positive correlations with the following factors: GDP, R&D, IPR, EDB and CPI. However, it negatively correlates with not only SLR but ROA and inflation as well. The correlation matrix indicates one correlation that is above the 0.8 level. Such high correlation can indicate a problem of collinearity, however in this case the correlation of 0.843 exists between IPR and CPI, two independent variables that are not being tested together and therefore there is no need for concern.

The influence of institutional development on the legitimation of start-ups

U

NIVERSITEIT VAN

A

MSTERDAM

Master Thesis

The Influence of Institutional Development on the

Legitimation of Start-ups

Statement of Originality

Acknowledgments

Abstract

Key Words:

Preface

Table of Contents

List of Tables and Figures

1 Introduction

2 Literature Review

2.1 Start-ups

2.2 Legitimation of Start-ups

2.3 Institutional Development

3 Theoretical Framework

3.1 Institutional Development and Amount of Capital

3.2 Institutional Development and Number of Capital Providers

3.3 Institutional Development and Reputation of Capital Providers

Amount of

Capital

Number of

Capital

Providers

Reputation of

Capital

Providers

4 Data and Method

4.1 Sample and Data Collection

4.2 Measurements

4.2.1 Dependent Variables

4.2.2 Independent Variables

4.2.3 Control Variables

4.3 Method and Model Specification

5 Data Analysis and Results

5.1 Descriptive Analysis

5.2 Statistical Analysis

5.2.1 Correlation Analysis