Fighting for Talent: Risk-Taking, Corporate Volatility, and Organizational Change

Abstract:     
We show that the availability of finance affects firms not only through financial markets, but also through the labor market. In our model, talented workers care for realizing their ideas because this can increase their lifetime income, but they also wish to be insured against income risk. Large firms are less likely to default and thus offer a safer income stream than small firms. But having assets, reputation or future cash flows of other projects at stake, large firms investigate new ideas more thoroughly than small firms. This investigation produces valuable but noisy information about the success probability of ideas. For this reason, large firms are more likely to reject good ideas than small firms. Workers thus face a trade-off between better insurance and lower probability of realizing their own ideas. If access to consumer credit increases, talented workers become less averse to the income risk of working in small firms and start spurning large firms. We show that this increases small firms' profit volatility and may induce large firms to create spin-offs. We also provide empirical evidence consistent with the implications of our theory.

Number of Pages in PDF File: 44

Keywords: Financial Development, Spin-offs, Sorting, Organizations, Markets

JEL Classification: L2, G3

working papers series