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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
14219.
Length: Date of creation: Aug 2008 Date of revision: Handle: RePEc:nbr:nberwo:14219
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Find related papers by JEL classification: G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure H1 - Public Economics - - Structure and Scope of Government L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
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