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THE IMPACT OF INFORMAL ENTREPRENEURSHIP ON INNOVATION

JUAN BU
Indiana University
Kelley School of Business
HH3100, 1309 E 10th Street, Bloomington, IN 47405

ALVARO CUERVO-CAZURRA
Northeastern University
D'Amore-McKim School of Business

INTRODUCTION

Informal entrepreneurship, starting up a business venture without registering with

government agencies, is a common phenomenon in emerging economies. Informal firms account
for more than half of all non-agricultural employment, approximately one-third of gross
domestic product (GDP), and provide livelihood for billions of people in developing and
emerging economies (Charmes, 2012; La Porta & Shleifer, 2014; Webb, Tihanyi, Ireland, &
Sirmon, 2009). This phenomenon has received increasing research attention in management,
with studies trying to explain the drivers of informal entrepreneurship. We extend research by
analyzing the impact of informal entrepreneurship on innovation in emerging economies.
We argue that informally created new ventures suffer from what we call are informality
costs, i.e., higher agency costs and weaker intellectual property and contract protection
mechanisms, that constrain their incentive and ability to invest in sophisticated innovations. As a
result, informally created new ventures engage more in imitative new product development and
less in innovative new product development. We also propose that the ultimate ownership of the
informally created formal new ventures modifies the informality costs as a result of differences
in agency costs and monitoring ability across types of owners. In comparison to independent
firms, ownership by foreign firms and private business groups compensates for the informality
costs, weakening the impact of informal creation on imitative and innovative new product
development; while state ownership heightens them, strengthening the impact of informal
creation on imitative and innovative new product development.

THEORY AND HYPOTHESES DEVELOPMENT

Informality Costs

Building on agency theory (Jensen & Meckling, 1976; Ross, 1973), we argue that there
exist significant costs associated with the lack of formal status, which we define as informality
costs, placing limits on the ability of informally-created firms to contract, operate, and grow.
These informality costs are driven by the challenges of establishing and maintaining contractual
relationships internally within the new venture and externally with third parties. First, informally
created new ventures face higher agency costs in their internal relationships than formally
created ones. Informally created firms may initially rely on the entrepreneurs and their family
members as employees. However, once the firms grow beyond the family members and need to
hire external employees, their informal status limits their ability to contract with external
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employees (Assenova & Sorenson, 2017), exacerbating the adverse selection and moral hazard
problems. Informal firms may not be able to provide benefits to their employees like healthcare
or contributions to social security and retirement benefits, discouraging the best employees from
joining. Informal firms also suffer from higher moral hazard problems in their ability to motivate
and control employees. The ability to incentivize employees to build up their skills to contribute
to the long-term competitiveness of the informal firm is limited. Moreover, employees may take
advantage of the informal status and extract capital and ideas from the company, knowing that
the informally created firm will find it challenging to prosecute them in court for intellectual
property theft because it is not a legal entity.
Second, informally created new ventures suffer from higher costs in their relationships
with external partners than formally created companies. Informal firms face challenges in their
ability to establish agency relationships and contract with suppliers and distributors because the
firms lack formal legal status. This creates additional adverse selection and moral hazard
problems. The best suppliers and distributors may not be willing to establish long-term
relationships with informal firms due to the difficulties of establishing formal contracts and the
concerns that the informal firms may disappear and renege on the contracts. Lacking long-term
oriented relationships in the supply chain increases the uncertainty and operation costs as well as
reduce the possibility of having supplier finance and an assured supply or distribution of larger
volumes. Informal short-term contracts constrain a firm’s ability to undertake long-term
investments and build relationships with the best suppliers and distributors. Also, informally
created firms may be expropriated by business partners because they have limited recurrence to
the formal contract settlement system of the judicial system in case of disputes with others (de
Mel, McKenzie, & Woodruff, 2013). Informally created firms may be also subject to abuse from
corrupt governmental officials but they do not have recourse to denounce the demands for bribes
because the firms are not legally registered (Djankov, Lieberman, Mukherjee, & Nenova, 2002).

Informal Entrepreneurship and Imitative and Innovative New Product Development

As a result of these informality costs, informally created new ventures are more likely to
introduce imitative new products and less likely to do innovative new products. Internally, the
relationships established within an informally created new venture suffer from informality costs
that lead managers and employees toward focusing on imitative new product development and
thwart the firm’s ability and willingness to conduct innovative new product development. First,
managers and employees in informally created new ventures are more short-term oriented in
their actions due to the previous inability to establish long-term contractual relationships.
Second, developing innovative new products not only tend to need much longer gestation periods
that managers of informally created firms may not have a feel for, but also require advanced
resources and sophisticated managerial capabilities as well as the commitment and effort of
employees to invest in innovation that the informally created new ventures may lack.
In external relationships, the informality costs limit a new venture’s subsequent ability to
undertake innovative new products and lead it toward imitative new products. First, the informal
and illegal status in the founding stage constrain the informally created new ventures from
establishing a long-term oriented, collaborative relationship with external organizations, limiting
their ability to innovate even after the formalization of the firm. Second, informally created new
ventures can become highly opportunistic in their pursuit of market opportunities, moving more
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quickly and aggressively than formally created companies, because they have been less
constrained in the protection of other firms’ innovations. We therefore hypothesize:

Hypothesis 1a. In emerging economies, the informal creation of formal new ventures is
positively related to imitative new product development.

Hypothesis 1b. In emerging economies, the informal creation of formal new ventures is
negatively related to innovative new product development.

Ownership, Informally Created Firms, and Innovation

We also propose that the informality costs are altered by different owners (i.e., foreign,
business groups, and state owners) that purchase these informally created new ventures.

Foreign Ownership, Informal Entrepreneurship, and New Product Development. We

propose that, in comparison to informally created new ventures that are still independently
owned, firms that started informally but now belong to foreign firms are more likely to engage in
innovative new products and less likely to develop imitative new products. First, informally
created new ventures that become part of foreign firms will have improved internal relationships
among managers and employees that support the development of innovative new products.
Second, by becoming part of a foreign firm, the informally created new venture establishes new
agency relationship within the network of subsidiaries that support its innovativeness. Finally,
having foreign ownership enables informally created firms to establish better agency
relationships with external partners, such as suppliers and distributors, and stronger relationships
against competitors, thus supporting the development of innovative new products. Hence,

Hypothesis 2a. In emerging economies, foreign ownership weakens the positive impact of
the informal creation of formal new ventures on imitative new product development.

Hypothesis 2b. In emerging economies, foreign ownership weakens the negative impact
of the informal creation of formal new ventures on innovative new product development.

Business Group Ownership, Informal Entrepreneurship and New Product Development.

Business groups, comprising of legally independent firms operating across diverse industries
(Khanna & Yafeh, 2007), are ubiquitous in emerging economies where they help fill institutional
voids through sharing critical resources, information, and experience among group members.
Internally, affiliation to the business group enhances the contractual and monitoring mechanisms
that were originally weak in the informally created new ventures. The integration within the
business group and the network of affiliated firms facilitates the development of innovations in
informally created new ventures. Finally, by being part of business groups, informally created
new ventures improve their external relationships that support the development of innovative
new products. Business group affiliation enables affiliated firms to establish new relationships
with external partners (e.g., distributors and suppliers) as these consider it easier to contract with
a firm that has the backing of the business group. We propose:
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Hypothesis 3a. In emerging economies, business group ownership weakens the positive
impact of the informal creation of formal new ventures on imitative new product
development.

Hypothesis 3b. In emerging economies, business group ownership weakens the negative
impact of the informal creation of formal new ventures on innovative new product
development.

State Ownership, Informal Entrepreneurship and New Product Development. In contrast

to foreign- and business group-owned informally created new ventures, state-owned ones are
more likely to reinforce imitative new product development and weaken innovative new product
development. Internally, state ownership and the associated risk aversion of employees in state-
owned firms heightens the informality costs, leading to a refocus on imitative new products
rather than innovative ones. Being state-owned integrates the informally created formal new
venture within a network of state-owned firms that create constraints on the ability of the new
venture to focus on innovation. Finally, in their external relationships, informally created new
ventures that become state owned may suffer from external partners’ reluctance of collaborating
with them in the development of new products, because the knowledge generated may be widely
dispersed to other state-owned firms. We therefore propose:

Hypothesis 4a. In emerging economies, state ownership strengthens the positive impact of
the informal creation of formal new ventures on imitative new product development.

Hypothesis 4b. In emerging economies, state ownership strengthens the negative impact of
the informal creation of formal new ventures on innovative new product development.

RESEARCH DESIGN AND RESULTS

We test the hypotheses on a sample of 11,973 formal new ventures (eight years old or
less) from 73 emerging economies during 2010-2016. Some of these formal new ventures started
operations informally and later formalized, while others started formally. Our analysis captures
whether the differences between informal and formal entrepreneurship have impact on the
subsequent innovation even after the new ventures have already formalized. We employed firm-
level data from the World Bank’s Enterprise Surveys (WBES) and obtained country-level data
from multiple sources including the World Bank, the World Economic Forum, etc.
We measured imitative new product development as a bivariate variable coded as 1 if a
firm introduced products or services which are new to the firm but are not new to the market, and
coded as 0 otherwise; and innovative new product development as a bivariate variable coded as 1
if a firm introduced new products or services that are also new to the market, and coded as 0
otherwise. We measured informal entrepreneurship as a bivariate indicator with a value 1 if a
new venture was not formally registered when it began operations and a value 0 if it was
formally registered when it started operations. We measured the three moderators – foreign
ownership, business group ownership, and state ownership – using three dummies to indicate if
the three types of ownership are a firm’s dominant ownership (1 if yes, and 0 if no). We further
controlled for firm-, industry-, country-, and time-level variables including firm age, firm size,
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R&D, top manager’s experience, training, GDP growth, GDP per capita, regulatory efficiency,
national innovation system, political environment, and industry dummies.
We employed multilevel mixed-effects logistic regression in our analyses to test the
proposed hypotheses. Table 1 presents the results. We find that formal new ventures that were
informally created are more likely to introduce imitative new products and less likely to
introduce innovative new products than new ventures that started life as formal firms. We also
find that informally created formal new ventures that become part of private business groups are
more likely to introduce innovative new products, while those that become state-owned are less
likely to introduce innovative new products. Surprisingly, we do not find that foreign ownership
alters the innovativeness of informally created new ventures, but we find that foreign-owned
firms are more likely to introduce innovative new products.

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Table 1 about here
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DISCUSSION AND CONCLUSIONS

This study contribute to two streams of literature: the topic of innovation in emerging
economies, and agency theory. First, we extend the literature of innovation in emerging
economies by finding an important and little-discussed antecedent that influences innovation,
that is, the informal creation of new ventures, which is a common phenomenon across emerging
countries. The usual view is that firms in emerging economies suffer in their innovativeness
because of the limitations in the innovation systems in the country (Freeman, 1995). We
introduce another and novel driver of innovation in emerging markets, their informal creation,
which is prevalent in emerging economies (ILO, 2013; Klapper, Amit, Guillen, & Quesada,
2007). We also help better understand this topic by analyzing how ownership alters the
relationships. Being owned by another firm modifies the informality costs, but this modification
depends on the agency relationships and costs that the owners have in place.
Second, the arguments contribute to the extension of agency theory in the realm of
innovation. The theory has been traditionally used to explain ownership relationships (Fama &
Jensen, 1983; Jensen & Meckling, 1976). However, the theory is much more flexible, and here
we show how it can be extended to analyze informally created companies, which are rarely
studies despite their prevalence in emerging economies. We extended the theory by introducing
the concept of informality costs to explain the behavior of informally created firms and how they
have different agency costs in their internal relationships with employees and their external
relationships with partners. Informality costs is a new concept that helps connect the incentives
and ability of informally created firms to their strategic behavior, innovation in our case.

REFERENCES AVAILABLE FROM THE AUTHORS

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Table 1: Two-Level Logistic Model of Informal Entrepreneurship Effects on Innovation

Imitative new product Innovative new product
development development
Informal entrepreneurship (IE) 0.23[0.11]* -0.29[0.11]**
Foreign ownership (FO) -0.08[0.14] 0.32[0.11]**
FO × IE -0.87[0.77] 0.00[0.48]
Business group ownership (BGO) -0.09[0.10] 0.09[0.08]
BGO × IE 0.01[0.37] 0.97[0.30]**
State ownership (SO) 0.26[0.35] 0.26[0.28]
SO × IE 0.80[0.50] -0.94[0.52]†
Firm age 0.01[0.02] 0.03[0.01]*
Firm size 0.14[0.04]** 0.07[0.03]*
R&D 0.36[0.07]*** 1.39[0.06]***
Top manager's experience 0.00[0.00] 0.01[0.00]***
Formal training 0.10[0.07] 0.49[0.06]***
Employees at start-up -0.12[0.04]** -0.04[0.03]
GDP growth -0.06[0.04] 0.02[0.03]
GDP per capita -0.27[0.14]† -0.16[0.13]
Population 0.17[0.09]† -0.06[0.08]
Rule of law 1.64[1.07] 0.87[1.02]
Regulatory efficiency -0.77[1.31] -0.35[1.24]
Open markets -1.22[1.15] -0.03[1.11]
Innovation system -0.73[0.31]* -0.43[0.29]
Political stability 0.26[0.15]† 0.08[0.15]
Political democracy 0.03[0.02] 0.02[0.02]
Intercept 0.59[1.75] 0.66[1.65]
Variance of random intercept at country level 0.371[0.102] 0.372[0.085]
log likelihood -3915.62 -5369.16
Wald Chi-sq. 220.61*** 951.09***
Notes: N=11,973. The entries are unstandardized βs with [standard errors in brackets]. Significance level of two-tailed test.
Industry fixed effects and year fixed effects are included. †p<0.10; *p<0.05; **p<0.01; ***p<0.001.