Ebook Entrepreneurial Finance and Non-diversifiable Risk
Entrepreneurship plays an important role in fostering innovation and economic growth (Schumpeter (1934)). Entrepreneurial investment activities are quite diverse, ranging from the creation of the state-of-the-art high-tech products to the daily operations of small businesses (e.g., restaurants). Entrepreneurial businesses may differ from one another, but they have one important common feature: entrepreneurs are often exposed to non-diversifiable idiosyncratic risks from their investment projects. For reasons such as incentive alignment and informational asymmetry between entrepreneurs and financiers, entrepreneurs typically hold an undiversified portfolio, and thus bear non-diversifiable idiosyncratic risks. Moskowitz and Vissing-Jorgensen (2002) document that about 75 percent of all private equity is owned by house holds for whom it constitutes at least half of their total net worth. Moreover, households with entrepreneurial equity invest on average more than 70 percent of their private holdings in a single private company in which they have an active management interest. Hall and Woodward (2008) document that the idiosyncratic risks faced by entrepreneurs of startups are so large that, even with moderate risk aversion, they will be better off passing up projects with high expected payoffs.
The significant lack of diversification invalidates the standard finance textbook valuation analysis designed for firms owned by diversified investors. An entrepreneur’s non-diversifiable position in his investment project makes his business decisions (financing and project choice) and house hold decisions (consumption, saving, and asset allocation) interdependent. This interdependence arises in our model because markets are no longer complete for the entrepreneur. As a result, the standard two-step complete-markets analysis (i.e. first value maximization and then optimal consumption allocation) no longer applies. This non-separability between value maximization and consumption smoothing has important implications for real economic activities and the pricing of financial claims that an entrepreneur issues to finance his investment activities.
To the best of our knowledge, this paper provides the first dynamic incomplete-markets model of entrepreneurial investment and financing. We consider an infinitely-lived risk-averse entrepreneur who derives utility from his intertemporal consumption. He has an illiquid investment project, which he sets up as a firm with limited liability (the entrepreneurial firm). He can invest his liquid financial wealth in both a risk-free asset and a market portfolio. The entrepreneurial firm’s investment project generates a stream of stochastic cash flow, which are imperfectly correlated with the market portfolio. The entrepreneur trades dynamically in the market portfolio to hedge the systematic component of his business risks. However, the entrepreneur cannot fully hedge his project risks because they contain a non-diversifiable idiosyncratic component.
To reduce his idiosyncratic risk exposure, the entrepreneur resorts to outside risky debt and equity. Cashing out through outside equity financing, which takes the form of either an initial public offering (IPO) or a direct sale of the firm to diversified investors, gives the entrepreneur full diversification. Our model assumes that issuing outside equity (via either direct placement or IPO) requires the entrepreneur to pay a fixed cost. The fixed cost generates an option value of waiting, which implies that the entrepreneur will access external equity only when the diversification benefit from cashing out is sufficiently high. This feature is consistent the empirical evidence that debt is the primary source of external financing for small businesses (Heaton and Lucas (2004)).
Borrowing on the firm’s balance sheet using the illiquid project as collateral gives the entrepreneur an endogenous default option. As in standard trade off models of capital structure, default generates bankruptcy and agency costs. Unlike in these models, the default option here allows the entrepreneur to walk away from his business with limited liability, hence providing ex ante insurance to the entrepreneur against the firm’s potential poor performance in the future.
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