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Risk Taking by Entrepreneurs

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Galina Vereshchagina of Arizona State University, and Hugo A. Hopenhayn of UCLA.)

Entrepreneurial activity is risky and poorly diversified. Most economic models would suggest that the high degree of entrepreneurial risk should be compensated by premium returns, but this is not borne out by the empirical evidence. Several hypotheses based on the idea that entrepreneurs have a different set of preferences or beliefs (e.g. risk tolerance or over-optimism) have been offered to explain this anomaly. In our forthcoming American Economic Review paper, Risk Taking by Entrepreneurs, we provide an alternative theory of endogenous entrepreneurial risk taking that does not rely on individual heterogeneity of preferences or beliefs.

The key ingredients in our theory are borrowing constraints, the existence of an outside opportunity and endogenous risk choice. A self-financed entrepreneur chooses every period how much to invest in a project, which is chosen from a set of alternatives. All available projects offer the same expected return but a different variance. After returns are realized, the entrepreneur decides whether to exit and take the outside opportunity (e.g. become a worker) or to stay in business. The possibility of exit creates a non-concavity in the entrepreneurs’ continuation value: for values of wealth below a certain threshold, the outside opportunity gives higher utility; for higher wealth levels, entrepreneurial activity is preferred.

Risky projects provide lotteries over future wealth that eliminate this non-concavity and are particularly valuable to entrepreneurs with wealth levels close to this threshold. As the level of wealth increases, entrepreneurs invest in less risky projects. In order to stress the role of risk taking, our model allows entrepreneurs to choose completely safe projects with the same expected return. All exits occur precisely because low wealth entrepreneurs purposively choose risk. If risky projects were not available, no entrepreneurs would ever exit from business. It is the relatively poor entrepreneurs that decide to take more risk. At the same time, due to self-financing, they invest less in their projects than richer entrepreneurs. Correspondingly, the model implies that survival rates of the business are positively correlated with business size. Moreover, if agents enter entrepreneurship with relatively low wealth levels (as occurs in the case with endogenous entry that we study), our model also implies that young businesses exhibit lower survival rates. It also appears that, conditional on survival, small (younger) firms grow faster than larger (older) ones.

One of the main contributions of our work is that we actually provide a very intuitive interpretation for lotteries?entrepreneurial project risk choice. This enables us to relate the implications of our model not only to the firm dynamics stylized facts, but also to the broad empirical evidence on entrepreneurial risk taking and the private equity premium puzzle. In addition, by incorporating the project risk choice in an occupational choice model with exogenous borrowing constraints, we are also able to illustrate how lotteries might lead to expected gains in lifetime consumption and can be used to relax the borrowing constraints.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 10, 2009 (boomark / email).