Dynamics of Entrepreneurship Under Incomplete Markets

Abstract:     
An entrepreneur faces substantial non-diversifiable business risk and liquidity constraints, both of which we refer to as frictions. We show that these frictions have significant economic effects on business start-up, capital accumulation/asset sales, portfolio allocation, consumption/saving, and business exit decisions. Compared with the complete-markets benchmark, these frictions make entrepreneurs invest substantially less in the business, consume less, and allocate less to the market portfolio. The endogenous exit option provides flexibility for the entrepreneur to manage downside risk. The entrepreneur's optimal entry decision critically depends on the outside option, the start-up cost, risk aversion, and wealth. We show that the flexibility to build up financial wealth before entering into entrepreneurship is quite valuable. Finally, we provide an operational framework to calculate the private equity idiosyncratic risk premium for an entrepreneurial firm and show that this premium depends on entrepreneurial wealth, non-diversifiable risk exposure, and risk aversion.

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