By Luis Cabral and Zhu Wang
December 2008; Revised July 2009
RWP 08-15
Research Division
Federal Reserve Bank of Kansas City

We develop a "passive learning" model of firm entry by spin-off: firm employees leave their employer and create a new firm when (a) they learn they are good entrepreneurs (type I spin-offs) or (b) they learn their employer's prospects are bad (type II spin-offs). Our theory predicts a high correlation between spin-offs and parent exit, especially when the parent is a low-productivity firm. This correlation may correspond to two types of causality: spin-off causes firm exit (type I spin-offs) and firm exit causes spin-off (type II spin-offs). We test and confirm this and other model predictions on a unique data set of the U.S. automobile industry. Finally, we discuss policy implications regarding "covenant not to compete" laws.