If you were looking for a new job, which company would you rather apply to: one with sound financials, or one with a risky or even distressed fiscal position? All else being equal, anyone would probably choose the former, healthier company—and not even bother applying to the latter. That distressed firms have trouble attracting job applicants seems like an intuitive, obvious truth. But according to the Kellogg School of Management's Jennifer Brown and David Matsa, nobody has empirically investigated this piece of economic "common sense."

"There isn't really any hard evidence quantifying the labor-supply response to a company's financial risk," says Matsa. His and Brown's new paper not only validates the intuition that job seekers avoid shaky companies, but also measures the magnitude of this effect.

Talent Doesn’t Show Up on a Balance Sheet 

For Brown, whose research centers on human-resource economics, examining the "sinking ship" effect had an obvious appeal. "Distress can reinforce distress," she says. "When your firm is struggling more than average, you're going to have do something extra to overcome job seekers' reluctance to come on board—but this can be difficult to do from a distressed position. A better understanding of this indirect cost could help you avoid getting into the distress in the first place."

“These applicants weren’t interested enough to create even the possibility of getting a job offer at a distressed firm. They just didn’t apply.”

Matsa says he was interested in quantifying how this aversion of job applicants towards distressed firms affects the firms' overall economic position. "Financial constraints are easy to measure on a balance sheet," he says. "But distress doesn't only constrain physical capital—it constrains human capital as well. And our findings suggest that this loss of human capital is also important."

In the past, economists have attempted to measure this "sinking ship" effect indirectly by comparing wages offered in industries with frequent layoffs to wages offered in more-stable sectors. Brown and Matsa designed a more direct approach by gaining access to survey and application data from a large job-search website. (The site shared its data with the researchers on the condition that they not reveal the site's name.) "People might say they don't want to work at unhealthy firms, but with this [information provided by the job-search website], we are able to look at what they actually do," Brown explains.

Survey Says ...

In order to assess whether job applicants avoid distressed firms, Matsa and Brown first had to determine whether the applicants could accurately determine which firms were healthy and which were not. The authors used data from surveys conducted by the job-search website between October 2008 and March 2010, which asked thousands of applicants to rate the financial health of firms on a scale of one to five. Brown and Matsa measured the "true financial health" of the companies by examining their credit default swap (CDS) prices. By comparing these two datasets, the authors could assess how accurate the job applicants' opinions were about companies' financial health. "We were looking for correlations between perceptions and reality," Brown says.

Credit default swaps are the canaries in the coalmine of a firm's financial operations: the higher the CDS price, the shakier the firm's future. "CDS is insurance against a firm defaulting on its bonds," Matsa explains. "You could think of it as an indicator of how likely this firm is to default on its debt and then, as a result, potentially lay off workers."

That said, Brown and Matsa were not suggesting that job seekers were literally tracking CDS prices to assess which firms were worth applying to. "A lot of their awareness is probably coming from the newspaper or from friends at the company," Matsa says. He and Brown found agreement between job seekers' intuitive or indirect assessments of a company's financial health and that company's actual health, as reflected in CDS prices.

Not Even Worth Applying For

But what do job applicants do, if anything, with this information? Brown and Matsa were given access to actual job applications from the online job-search site (narrowed to a specific industry, the financial sector). This let the authors see exactly what job openings were being advertised at which firms, what the educational requirements for them were, and where each applicant was located by zip code. (Names and other personal details were not shared.) The performance of financial-services firms during the recent fiscal crisis made them an attractive target for this close analysis. "There were some firms that did well, and others that had quite dramatic changes in their financial health," says Brown. "It gave us nice variation."

Using this data, the authors were able to make detailed comparisons between identical job openings at distressed firms and healthy firms. They found that distressed firms received significantly fewer applications compared to the healthy companies: about 20% fewer applications for every 1,000-basis point increase in a firm's CDS price. "We were surprised that the effect was so large," Brown says. "These applicants weren't interested enough to create even the possibility of getting a job offer at a distressed firm. They just didn't apply."

This "sinking ship” effect, conclude the authors, only exacerbates the problems that a distressed firm is trying to correct. In a distressed company, job vacancies with high educational requirements—which might normally attract high-quality applicants who could contribute to improving the company's fortunes—become the hardest to fill. High-quality workers also become much less likely to relocate for a job at a distressed company, restricting the talent pool even further. Indeed, Brown and Matsa's findings show that the average quality of job applicants falls with a firm's decreasing financial health. Attempts to compensate, such as offering higher wages, "don't completely offset the effect," says Brown.

All of which makes the "sinking ship” effect, according to Brown and Matsa's findings, a drag on a distressed company's ability to right itself. "The main lesson is to avoid getting your company into this situation," Matsa says. Because, as Brown and Matsa's findings demonstrate, if a company is unlucky enough to be in dire straits, it may have trouble attracting workers who can turn things around.