Entrepreneurial Ability, Venture Investments and Risk Sharing

Posted: 17 Nov 2009

See all articles by Raphael ('Raffi") H. Amit

Raphael ('Raffi") H. Amit

The Wharton School UPENN

Lawrence R. Glosten

Columbia Business School - Finance and Economics

Eitan Muller

affiliation not provided to SSRN

Date Written: 1990

Abstract

This study seeks to fill a gap in the research on the behavior of entrepreneurs, their decisions to develop their firms independently or with venture capitalists, and the relation to their abilities and to the value in making that ability known, even at a cost. Information asymmetry exists when venture capitalists find it difficult to assess the founder's entrepreneurial skills and abilities, which can impact the decision of entrepreneurs to seek venture capitalists, and the price that those investors may be willing to pay. A model is developed based on the principal-agent framework, which focuses on a risk-adverse entrepreneur in an independent setting, and is used to address three different situations concerning outside knowledge of an entrepreneur's abilities. The model shows that when the ability of entrepreneurs is common knowledge, they choose to involve risk-neutral venture capitalists. When the entrepreneur knows his or her skill level, but the venture capitalist does not, the less profitable ventures are the ones that are sold. The more skillful entrepreneurs retain their ventures. In situations where asymmetric information exists, it is possible for the entrepreneur to invest in information that makes his skill level known to the venture capitalists. When this happens, some less skillful entrepreneurs will still sell. An examination of equilibrium prices under this set of circumstances shows that the price for those ventures that are sold without using an available signal will be less than, or equal to, the prices of the ventures that are sold when a signal is not available. Highly-skilled entrepreneurs do not necessarily either generate a signal or develop their venture alone. The results of this analysis help to explain Bygrave's work that highlighted the poor return of venture capital investments. (SRD)

Keywords: Signaling, Agency theory, Risk orientation, Information asymmetry, Behavior (individual), Skills, Firm financing, Early stage financing, Startups, Venture capitalists, Moral hazard problem

Suggested Citation

Amit, Raphael H. and Glosten, Lawrence R. and Muller, Eitan, Entrepreneurial Ability, Venture Investments and Risk Sharing (1990). University of Illinois at Urbana-Champaign's Academy for Entrepreneurial Leadership Historical Research Reference in Entrepreneurship, Available at SSRN: https://ssrn.com/abstract=1505198

Raphael H. Amit (Contact Author)

The Wharton School UPENN ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6370
United States
215 898 7731 (Phone)

Lawrence R. Glosten

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Eitan Muller

affiliation not provided to SSRN

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