Regulating Entrepreneurship: The Case of Capital Requirements

Governments have a long history of regulating entrepreneurs’ use of limited liability by mandating a minimum amount of paid-in equity. While opponents argue that these requirements pose an unnecessary barrier to entrepreneurship, proponents maintain that they protect stakeholders, in part by screening out low-quality entrepreneurship. We exploit a 2012 Norwegian reform that lowered the capital requirement from $17,000 to $5,000 to study this quantity-quality trade-off. Our setting includes detailed data on both firms and the underlying entrepreneurs, providing comprehensive proxies for entrepreneurial quality. We first show that incorporation rates double after the reform and remain elevated over time. Post-reform entrants are considerably smaller in terms of assets and revenues but do not differ in terms of growth, survival rates, profitability, productivity, or leverage. Furthermore, post-reform entrants have similar past income levels, age, and educational attainment as pre-reform entrants. We further find no difference in educational achievement, captured by proxies for quantitative skills, communication skills, physical ability, and illicit traits. Thus, while the reform led to an influx of smaller firms, there is no indication that new entrepreneurs or their firms were riskier or of lower quality. These findings challenge the existing motivation for capital requirements. In explaining the mechanism behind the increase in entry, we find no evidence that the reform alleviated financial constraints. Rather, our empirical findings and enriched entry model suggest that returns-to-scale heterogeneity plays an important role. Optimally small entrepreneurs have more concave production functions and only enter when capital requirements are low.