Firm Dynamics and the Return to Entrepreneurship

Abstract

This paper connects the return to entrepreneurship and firm growth decisions in a dynamic investment model with limited access to external financing. When additional assets can effectively relieve financing constraints, the entrepreneur values dollar return more than its face value for firm expansion. The desire for expansion aggravates the agency problem, resulting in a high cost of capital and low dollar return to entrepreneurship in equilibrium. Firms may be locally risk-loving or risk-averse even if entrepreneurs have risk-neutral preferences. They may remain small despite their ability to grow through cash flow reinvestments. Relaxing financing constraints may have a non-monotonic effect on firm dollar returns.

Keywords: Access to External Finance, Firm Dynamics, Private Equity Premium Puzzle, Growth Trap

JEL Classification: D21, G21, G31, L25