Entrepreneurs, Risk Aversion, and Dynamic Firms

Abstract

This paper conducts a theoretical and quantitative analysis of how entrepreneurs choose firm size, capital structure, default, and owner consumption to manage firm risk, including how these choices change with risk aversion. We decompose an entrepreneur's default decision into three elements: the fraction of firm debt; the potential reduction in personal consumption from losing the firm; and the ratio of personal wealth to firm scale, which determines an entrepreneur's ability to inject personal funds to continue operation. Data from the Survey of Small Business Finances is used to calibrate the model and estimate entrepreneur risk aversion. We determine the evolution of entrepreneur net worth, consumption, and firm assets over time. We find that many entrepreneurs have lower net worth and consumption than non-entrepreneurs with the same preferences, but the densities of the distributions of consumption and net-worth have wide upper tails. Thus, entrepreneurship can be a path toward great wealth and high consumption for the top quantiles of entrepreneurs.

Inspired or Foolhardy: Sensemaking, Confidence and Entrepreneurs’ Decision-Making

“…At first sight, this may seem naïve on the part of new entrepreneurs, a characteristic which Goel and Karri (2006) may consider as over-trust in the nurturing potential of the environment. However, instead of consigning new entrepreneurs to the fate of unknown vulnerability (Cressy 2006), one should also consider how risk-aversion, developed through experience, may lead to a creeping conservatism in established entrepreneurs, perhaps artificially holding the firm back from innovation and growth (Herranz et al 2015). The boldness of new entrepreneurs, supported by this study's findings, can be seen as a necessary trait to push the business forward, conceptually linking entrepreneurial confidence to more innovative and forward-looking perspectives of the environment (Ribeiro- Soriano and Urbano 2009;Soriano and Huarng 2013).…”

Loss Aversion, Transaction Costs, or Audit Trigger? Learning About Corporate Tax Compliance from a Policy Experiment with Withholding Regime

“…The evidence thus suggests that the behavior of a subset of firms is not consistent with the widelyused linear preference prospect theory model with loss aversion and reference dependence. 8 We provide additional evidence consistent with the AT (Audit Trigger) model by exploiting a substantial body of theoretical literature and empirical evidence that firm size (measured in terms of assets) is negatively correlated with risk averseness of a firm (Herranz et al (2015), Greenwald and Stiglitz (2013)). Under the null hypothesis that the audit trigger model is correct, the firms in the middle of the asset size distribution are the most likely to bunch, implying that the relation between the assets and propensity to bunch is inverted U shaped.…”

“…This is strong evidence against the hypothesis that if a firm bunches in one year, it should also bunch in the other years if the enforcement and withholding regime is unchanged, and raises doubts about the LPT model as a description of the central tendency in the data. 25 However, as noted in testable prediction (TP.3.2), a firm that bunched in year t can unbunch in the year t + 1 under the LPT model when it experiences shocks such that its true refund switches from negative (in t ) to positive (in t + 1). The testable implication of LPT model in such cases of unbunching is that they will declare taxes less than the withheld amount in the year they unbunch.…”

“…This has important implications for persistence in bunching over time. If a firm bunches at the withholding threshold in year t, it will bunch in all other years when P , θ, and δ remain the same, because the changes in revenue and costs over the years do not affect the bunching decision so long as true tax liability remains higher than the 19 The available evidence shows that the small firms use less debt and buy less insurance (Herranz et al (2015), Collier et al (2016)). For evidence that large firms are more able to withstand negative shocks by using their better access to credit market, see Khwaja and Mian (2008).…”

An Estimated Structural Model of Entrepreneurial Behavior

“…The tendency of entrepreneurs to save at higher rates and invest much of their wealth in their own businesses suggests the presence of financial constraints (Quadrini, 2000(Quadrini, , 2009Cagetti and De Nardi, 2006;Herranz et al, 2015), as does evidence that inheritances improve their chances of survival (Holtz-Eakin et al, 1994).…”