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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.

Suggested Citation

  • Robert E. Hall & Susan E. Woodward, 2008. "The Burden of the Nondiversifiable Risk of Entrepreneurship," NBER Working Papers 14219, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14219
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    References listed on IDEAS

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    1. Rafael Repullo & Javier Suarez, 2004. "Venture Capital Finance: A Security Design Approach," Review of Finance, European Finance Association, vol. 8(1), pages 75-108.
    2. Catherine Casamatta, 2003. "Financing and Advising: Optimal Financial Contracts with Venture Capitalists," Journal of Finance, American Finance Association, vol. 58(5), pages 2059-2086, October.
    3. Admati, Anat R & Pfleiderer, Paul, 1994. " Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, vol. 49(2), pages 371-402, June.
    4. Klaus M. Schmidt, 2003. "Convertible Securities and Venture Capital Finance," Journal of Finance, American Finance Association, vol. 58(3), pages 1139-1166, June.
    5. Gompers, Paul & Kovner, Anna & Lerner, Josh & Scharfstein, David, 2010. "Performance persistence in entrepreneurship," Journal of Financial Economics, Elsevier, vol. 96(1), pages 18-32, April.
    6. 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.
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • 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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