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The Burden of the Nondiversifiable Risk of Entrepreneurship

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  • Robert E. Hall
  • Susan E. Woodward

Abstract

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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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14219.

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Date of creation: Aug 2008
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Publication status: published as Robert E. Hall & Susan E. Woodward, 2010. "The Burden of the Nondiversifiable Risk of Entrepreneurship," American Economic Review, American Economic Association, vol. 100(3), pages 1163-94, June.
Handle: RePEc:nbr:nberwo:14219

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  1. Repullo, R. & Suarez, J., 1998. "Venture Capital Finance: a Security Design Approach," Papers, Centro de Estudios Monetarios Y Financieros- 9804, Centro de Estudios Monetarios Y Financieros-.
  2. Robert E. Hall & Susan E. Woodward, 2007. "The Incentives to Start New Companies: Evidence from Venture Capital," NBER Working Papers 13056, National Bureau of Economic Research, Inc.
  3. Klaus Schmidt, 1999. "Convertible Securities and Venture Capital Finance," CESifo Working Paper Series 217, CESifo Group Munich.
  4. Schmidt, Klaus M., 2003. "Convertible Securities and Venture Capital Finance," Munich Reprints in Economics, University of Munich, Department of Economics 19769, University of Munich, Department of Economics.
  5. Gompers, Paul & Kovner, Anna & Lerner, Josh & Scharfstein, David, 2010. "Performance persistence in entrepreneurship," Journal of Financial Economics, Elsevier, Elsevier, vol. 96(1), pages 18-32, April.
  6. Casamatta, Catherine, 2002. "Financing and Advising: Optimal Financial Contracts with Venture Capitalists," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3475, C.E.P.R. Discussion Papers.
  7. Admati, Anat R & Pfleiderer, Paul, 1994. " Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, American Finance Association, vol. 49(2), pages 371-402, June.
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Cited by:
  1. Ross Levine & Yona Rubinstein, 2013. "Smart and Illicit: Who Becomes an Entrepreneur and Does it Pay?," CEP Discussion Papers dp1237, Centre for Economic Performance, LSE.
  2. Ramana Nanda & Matthew Rhodes-Kropf, 2012. "Innovation and the Financial Guillotine," Harvard Business School Working Papers 13-038, Harvard Business School, revised Dec 2012.
  3. William R. Kerr & Ramana Nanda & Matthew Rhodes-Kropf, 2014. "Entrepreneurship as Experimentation," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 28(3), pages 25-48, Summer.
  4. Hvide, Hans K. & Panos, Georgios A., 2013. "Risk Tolerance and Entrepreneurship," IZA Discussion Papers 7206, Institute for the Study of Labor (IZA).
  5. Hui Chen & Jianjun Miao & Neng Wang, 2010. "Entrepreneurial Finance and Nondiversifiable Risk," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 23(12), pages 4348-4388, December.
  6. Wang, Chong & Wang, Neng & Yang, Jinqiang, 2012. "A unified model of entrepreneurship dynamics," Journal of Financial Economics, Elsevier, Elsevier, vol. 106(1), pages 1-23.
  7. Nanda, Ramana & Rhodes-Kropf, Matthew, 2013. "Investment cycles and startup innovation," Journal of Financial Economics, Elsevier, Elsevier, vol. 110(2), pages 403-418.

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