Small firms are a vital part of the macroeconomy, producing more than 50 percent of non-farm private U.S. GDP, employing half of all private sector employees and paying 45 percent of total private payroll. They are a source of “good jobs,” generating 60 to 80 percent of net new jobs annually over the last decade, employing 41 percent of high tech workers (scientists, engineers and computer workers) and producing almost 14 times more patents per employee than larger patenting firms. Among all U.S. employer firms, 89 percent have less than 20 employees. Unlike large firms, they are closely associated with their owners. We quantify the effects of two owner traits, risk aversion and optimism, and policies regarding bankruptcy and credit access, on firm size, capital structure and default. The distinction between policies and owner traits is important because policies can be changed but innate characteristics cannot.
We construct a model economy with a risk neutral representative lender and many long-lived agents who differ in willingness to bear risk. Each period, agents choose consumption and whether to run a firm with risky returns. If they run a firm, they choose its size, capital structure (mix of personal funds and outside loans), and whether to default ex-post. Firm risk is non-tradable (i.e., the owner runs a single firm, not a portfolio of firms) and firms may be credit constrained. Default occurs in equilibrium, with the lender recovering only a fraction of the loan and the firm unable to obtain credit for several periods. Firms weigh the effect of default today against access to future credit. We show that modest differences in risk interact with institutions to generate significant welfare effects that affect firm legal status. The less risk-averse run larger firms with higher future value and this limits their incentive to default, hence they incorporate to protect current personal assets. In contrast, if the more risk averse run firms they are small with lower future value. It may be optimal for such owners to leave some personal assets at risk in bankruptcy by remaining unincorporated. The fact that these assets would be seized credibly limits their default ex post.
In both England and the U.S. early bankruptcy law applied only to merchants, not consumers. Supporters of the U.S. Bankruptcy Act of 1800 argued that “unforeseen accidents” were ruining respectable merchants and there was substantial social value in returning these merchants to active business (see Mann (2003), note 11, pp. 57 and 73). The fundamental role of corporate law was to limit liability (see Hovenkamp (1991), pp. 49-55). We model these unforeseen accidents and limited liability, and show that bankruptcy insures owners against poor firm returns but permits upside gain, even after accounting for the impact of default on loan interest rates. This insurance induces risk-averse entrepreneurs to operate larger firms, which leads to higher output and welfare, while the option value of maintaining the firm to realize future value limits default.
Because the goal of bankruptcy is to limit risk, an agent’s attitude towards uncertain returns is crucial (e.g., the same bankruptcy rule will have different implications for owners with different degrees of risk aversion). Thus, we allow for heterogeneity and use the model to derive a distribution of risk aversion for those who choose to become entrepreneurs. Apart from bankruptcy, firms can also manage risk through decisions such as financial structure, scale of production and the amount of personal net-worth to invest. We show how these optimal decisions depend on differences in owner risk aversion. Finally, accounting for heterogeneous risk aversion and uncertain firm returns requires us to derive cumulative probability distribution functions for firm decisions. We compare model predictions to distributions constructed from data. The discipline imposed by this check for consistency between model predictions and data is the analog of matching moments in quantitative macroeconomic models (cf., Prescott (2006)).
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