Entrepreneurs, Contracts, and the Failure of Young Firms

Although economic theory has emphasized that moral hazard and hold-up problems influence the design of contracts, very little is known about the process by which explicit contracts are established and the effect of contractual arrangements on firm performance. This paper attempts to demonstrate that firms are selected for survival on the basis of contracting efficiency. Based on a statistical analysis of 170 new franchise contracts and interviews with the founders of 16 of these new franchise systems, we show that new franchise chains that adopt exclusive territories are more likely to survive over time than chains that do not. Moreover, successful and failed entrepreneurs possess different information about how to design contracts. These entrepreneurs undertake “contractual experiments” based on the information they possess. Those whose experiments prove to be more consistent with economic theory are rewarded for their superior information with survival.