Entrepreneurial Finance and Nondiversifiable Risk

Abstract

We develop a dynamic incomplete-markets model of entrepreneurial firms, and demonstrate the implications of non-diversifiable risks for entrepreneurs’ interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. We characterize the optimal capital structure via a generalized tradeoff model where risky debt provides significant diversification benefits. Non-diversifiable risks have several important implications: more riskaverse entrepreneurs default earlier, but choose higher leverage; lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and risky debt partially alleviates this problem; entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also analytically characterize the idiosyncratic risk premium.

Keywords: default, diversification benefits, entrepreneurial risk aversion, incomplete markets, idiosyncratic risk premium, hedging, capital structure, cash-out option, precautionary saving

JEL Classification: G11, G31, E2