Matching of Individuals for Start-Ups – A Test of the O-Ring Theory

Setting up a new firm is a complex process, which comprises many tasks. These different tasks require different qualifications. It can be expected that the required qualifications are provided by different persons, since one person alone cannot possess all relevant skills. Presumably, new firms are therefore founded in teams. Further, it can be assumed that the different tasks, which are to be performed in the course of establishing a firm, are interdependent in a way that a failure in the performance of a single task can put the whole project at risk. For example, the best business idea is not worth anything if it is not marketed appropriately to potential consumers. Thus, from the perspective of organisation theory, the establishment of a firm is an example of organising team work in a team of specialists. A way to formalise the idea of direct impact of the degree of task performance on output is the O-ring production framework (Kremer (1993), Fabel (2004)). The O-ring theory implies the segregation of individuals between firms according to their level of ability. Furthermore, the O-ring approach predicts that firm size and capital per head should increase with employees’ average level of ability. In this paper it is analysed to what extent the predictions of the O-ring theory are supported by the data. This study is also relevant from a policy perspective, as the O-ring theory can serve as a basis for guidelines to assist new firms. For the analysis, a rich register data set is used covering the whole population of firms founded in Denmark in 1998, as well as all individuals involved in these new firms in the start-up year and in the following three years. In order to analyse the extent of sorting of individuals between firms, statistical tests are constructed, which compare the actual distribution of individuals among firms with the distribution resulting from random assignment of individuals to firms. The results show that, contrary to the predictions of the theory, individuals with different levels of ability are more inclined to team up in new firms. Also contrary to the predictions of the theory, firm size and average level of ability of the involved individuals turn out to be negatively correlated. The only relationship that is predicted correctly by the theory is the positive relationship between capital per head and the average level of ability. In summary, the O-ring theory apparently does not provide a good description for the situation of young firms.

Müller, Bettina (2008), Matching of Individuals for Start-Ups – A Test of the O-Ring Theory, ZEW Discussion Paper No. 08-112, Mannheim.