Learning, Investment, and Entrepreneurial Survival: A Real Options Approach

Abstract:     
Empirical evidence shows that entrepreneurs on average do not earn more than paid employees in terms of the net present value (NPV). One natural question is what makes the entrepreneurs to stay in business. To address this question, we propose a continuous time real options model in which an entrepreneur does not know his investment quality and learn about it over time. We show that due to the option value of learning, an entrepreneur may stay in business even though the NPV is negative. We also show that risk aversion erodes option value and lowers private firm value so that a highly risk averse entrepreneur may exit even when the NPV is positive. In addition, a more risk averse or a more pessimistic entrepreneur exits earlier. Finally, the model can generate the positive relation between wealth and survival duration without liquidity constraints.

Number of Pages in PDF File: 35

Keywords: real options, learning, private firm value, survival, precautionary savings, incomplete markets

JEL Classification: D80, D91, G11, E21

working papers series