Starting a business is not a profitable activity: Hamilton [2000] documents that median entrepreneurial earnings after ten years of business are 35% less than the predicted alternative wage on a paid-job of the same duration. In addition, because the bulk of their wealth is invested in their own business, entrepreneurs bear a substantial amount of risk that only large private benefits can explain: Moskowitz and Vissing-Jorgensen [2003] estimate that entrepreneurs must enjoy non pecuniary benefits as high as 5 to 20% of their investment every year. These ”private benefits of control”, as the literature calls them, may correspond to pure hedonic flows: social status, the fun of running a firm or the independence that comes with it. However, in this case, one would be left with the puzzling fact that these benefits amount on average to some 150% of the entrepreneur’s annual income.
An alternative interpretation of these findings is that private benefits are pies in the sky: Entrepreneurs do not start new businesses because it is profitable, but because they wrongly believe it is. Many studies show that entrepreneurs typically overestimate the chances that their project will be successful. In their survey, Cooper, Woo and Dunkelberg [1988] find that 68% of entrepreneurs thought their own business would do better than their others’ (see also Pinfold [2000]). Experimental evidence suggests that people’s optimism about their own ability relative to their competitors’ leads to excess entry in a game of entrepreneurship (Camerer and Lovallo [1999]).
This paper examines and documents implications of the fact that entrepreneurial private benefits take the form of optimistic expectations. In a financial contracting framework, we find that differences in opinions between the (optimistic) entrepreneur and the (realistic) investor affect the optimal contract in a fashion similar to differences in objectives (agency conflict): in particular, optimistic entrepreneurs make more use of short term debt. Our results therefore stress the role of differences in opinions as a key determinant of capital structure, which has so far mostly been explained through agency considerations only. We then go to the data, document the large heterogeneity of entrepreneurial beliefs and find robust, convincing, evidence that short term debt is related to optimism, controlling for its usual determinants.
Our theoretical analysis shows that optimal contracts for optimists are contingent on events that the entrepreneur does not control (external risk), but holds overoptimistic expectations about. Two effects are at work: First, optimistic entrepreneurs inefficiently persist in implementing the initially ambitious project even if new information calls for a safer strategy. Hence, optimal contracts for optimists (short-term debt) transfer control to the investor in those states of nature where a realistic decision maker is needed. Secondly, an optimistic entrepreneur is willing to exchange cash flow rights in the low state (that he believes to be unlikely) against claims on the good state (that the investor knows to be unlikely). These differences in valuation across states of nature call for a contract that provides more upsides to the entrepreneur when he/she is optimistic.
Hence, modelling private benefits as optimism allows to reconcile some recent, apparently paradoxical, empirical findings with financial contracting theory. Common agency theory predicts that optimal contracts should insure the agent against risks he/she does not control. However, Kaplan and Stromberg [2002] have shown that VC backed entrepreneurs bear much more external risk than should be optimal. Along similar lines, one of the main lessons of CEO compensation literature is the surprising rarity of relative performance evaluation schemes (Murphy [2000], Bertrand and Mullainathan [2001]). These pieces of evidence conflict with common agency theory, but receive a natural interpretation in our framework: entrepreneurs or CEOs overestimate their chances of success. As a result, they have a strong preference for control and cash flow rights contingent on good states of nature.
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