The Burden of the Nondiversifiable Risk of Entrepreneurship
National Bureau of Economic Research, 2008 - Entrepreneurship - 24 pages
In the standard venture capital contract, entrepreneurs have a large fraction of equity ownership in the companies they found and are paid a sub-market salary by the investors who provide the money to develop the idea. The big rewards come only to those whose companies go public or are acquired on favorable terms, forcing entrepreneurs to bear a substantial burden of idiosyncratic risk. We study this burden in the case of high-tech companies funded by venture capital. Over the past 20 years, the typical venture-backed entrepreneur earned an average of $4.4 million from companies that succeeded in attracting venture funding. Entrepreneurs with a coefficient of relative risk aversion of two and with less than $0.7 million would be better off in a salaried position than in a startup, despite the prospect of an average personal payoff of $4.4 million and the possibility of payoffs over $1 billion. We conclude that startups attract entrepreneurs with lower risk aversion, higher initial assets, preferences for entrepreneurship over employment, and optimistic beliefs about the payoffs from their products.
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amount attract burden Career Wealth cash certainty-equivalent value coefficient of relative company exits Conditional Distribution declines distribution of exit Distribution of Venture diversified dynamic program Economic employees employment contracts entrepreneur receives entrepreneur's value entrepreneurial opportunity Entrepreneurship and Employment equity expected utility expected value eXt+i Extra Salary Figure 11 Finance Financial Contracting fraction high-value exits human capital idiosyncratic risk incentives individual investors Lifetime and Exit limited partners lower risk aversion Marginal Distribution marginal utility moral hazard NBER non-entrepreneurial job non-venture number of entrepreneurs outcomes partners of venture Payoffs to Entrepreneurs percent prior to Exit relative risk aversion risk-adjusted payoff risk-neutral Sand Hill Econometrics shareholders shows the paths standard venture startup ages startup company sub-market salaries take account total exit value U(Wt(At value function venture capital venture capitalists venture contract venture funding venture investments Venture Lifetime venture opportunity venture-backed companies venture-backed startup wealth-equivalent Woodward zero exit value zero-value exits