Entrepreneurs face significant nondiversifiable business risks. We build a dynamic incomplete markets model of entrepreneurial firms to demonstrate the important implications of nondiversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit (cash-out and default) decisions. The optimal capital structure is determined by a generalized tradeoff model where risky debt provides significant diversification benefits. Nondiversifiable risks have several important implications: (1) more risk-averse entrepreneurs default earlier, but optimally choose higher leverage, even though leverage makes his equity more risky; (2) lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and allowing for risky debt partially alleviates this problem; (3) entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also examine cash-out option and external equity as additional channels for diversification, and analytically characterize the idiosyncratic risk premium that under-diversified entrepreneurs demand for holding the firm.
This is a preprint version of an article published in The Review of Financial Studies. The final version may be found at < http://dx.doi.org/110.1093/rfs/hhq122 >.
Chen, Hui, Jianjun Miao, and Neng Wang. "Entrepreneurial Finance and Nondiversifiable Risk." Working paper, Columbia Business School, 2009.
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