We examine the financing choices of undiversified entrepreneurs in a continuous-time model. Entrepreneurs’ financing choices as well as their dynamic equity stakes, which trade off their private benefits and the costs they incur due to their lack of diversification, are simultaneously and endogenously determined. We characterize the equilibrium of the structural model and calibrate its parameters to aggregate data on the financing choices of young firms. Leverage increases with the drift or expected growth rate of the firm’s earnings and decreases with its volatility. Debt maturity varies in a U-shaped manner with the project’s drift and with its volatility. The predicted variations of leverage and debt maturity with the actual drift (controlling for the risk-neutral drift) of earnings are key distinguishing implications of our theory. These implications arise from the incorporation of agency conflicts between undiversified entrepreneurs and well-diversified outside investors, and cannot, therefore, be obtained in traditional capital structure models in which all agents are well-diversified. We also derive additional novel implications that link entrepreneur-specific characteristics---their discount rate or “degree of myopia” and their cost of risk---to leverage and debt maturity.
We investigate the financing decisions of entrepreneurial firms in a continuous-time framework. Our model incorporates the effects of agency conflicts between undiversified entrepreneurs, who derive non-pecuniary private benefits from their ownership stakes, and well-diversified outside investors. In our symmetric information framework with no taxes or bankruptcy costs, a cash-constrained entrepreneur finances a firm’s projects with a combination of debt, inside equity and outside equity. The entrepreneur’s financing choices and her dynamic equity stake in the firm reflect the inter-temporal interplay among the private benefits she derives from her ownership stake, the costs she incurs due to her resulting lack of diversification, and the loss of private benefits due to bankruptcy.
We characterize the equilibrium of the structural model and calibrate its parameters to aggregate data on the capital structure choices of young firms. We show that leverage increases with the drift or expected growth rate of earnings. Debt maturity varies non-monotonically in a U-shaped manner with the drift and the volatility of earnings. Our results potentially reconcile empirical findings regarding the variations of leverage and debt maturity with project characteristics that are not completely consistent with previous theories. The significant variation of capital structure with the actual drift of earnings (controlling for the risk-neutral drift) are important predictions of our study. These implications arise from the incorporation of agency conflicts between undiversified insiders and well-diversified outside investors and cannot, therefore, be obtained in models in which all agents are well-diversified. It follows from the theory of “contingent claims” (or risk-neutral) valuation that financing choices in these models only depend on the risk-neutral distribution of earnings (see Fischer et al, 1989, Leland and Toft, 1996, Duffie, 2001).
In our continuous-time framework, a cash-constrained entrepreneur finances a positive NPV project through a combination of her personal wealth (or “inside” equity), debt and outside equity. The entrepreneur invests the portion of her initial wealth that is not invested in the project in a diversified portfolio. Capital provision by outside investors is competitive so that the entrepreneur captures the project surplus. In our symmetric information framework with no taxes or bankruptcy costs, the market value of the firm the value of earnings from the perspective of well-diversified outside investors is unaffected by leverage as in the Modigliani-Miller world. As we discuss shortly, however, the entrepreneur is not indifferent to the choice of leverage.
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Leverage and Debt Maturity Choices by Entrepreneurial Firms
