Dynamics of Entrepreneurship under Incomplete Markets
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An entrepreneur faces non-diversi able business risk and liquidity constraints. We provide a uni ed framework that embeds these frictions to study interdependent business start-up/entry, capital accumulation/asset sales, portfolio allocation, consumption/saving, and business exit decisions. Liquid wealth mitigates nancial constraints and critically influences the entrepreneur's decision making. An entrepreneur invests less in business, consumes less, and allocates less to the market portfolio in order to preserve liquidity for precautionary purposes. We develop the counterpart of the q theory of investment for rms run by non-diversi ed entrepreneurs, and propose corresponding measures for average q and marginal q. Corporate investment depends on both marginal q and the marginal value of wealth. The wedge between average q and marginal q is non-monotonic in liquidity. With illiquid capital stock, the endoge- nous liquidation option provides signi cant exibility for the entrepreneur to manage downside risk, causes rm value to be convex in liquidity and investment to decrease in liquidity near the endogenous exit boundary. The exibility to accumulate wealth before entering entrepreneurship is highly valuable, and the wealth e ect is signi cant for entrepreneurship. The optimal entry decision critically depends on the outside op- tion, the start-up cost, risk aversion, and wealth. Heterogeneity among entrepreneurs is thus important. Our model yields an operational framework to calculate the private equity idiosyncratic risk premium. Quantitatively, the interactive e ffects of incomplete-markets frictions and capital illiquidity on investment and value are signi cant.
The article of record as published may be located at http://dx.doi.org/10.2139/ssrn.1767429
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