Risk-averse Entrepreneurs Research Articles

Financing green entrepreneurs under limited commitment

Risk-averse entrepreneurs interact with financiers to fund their projects. Projects can be operated under green or dirty technologies. We explore the role of limited commitment in determining the adoption of green technologies when governments enact carbon taxes and/or directed investment subsidies. We show that entrepreneurial (respectively, financier) limited commitment makes it more (less) costly for governments to encourage green technology adoption. Because green technologies are still at an early stage, the cash flows they generate are back-loaded. Entrepreneurial limited commitment forces consumption to increase over time, thereby undermining risk-sharing and making dirty technologies more attractive. By contrast, under financier limited commitment, the possibility that front-loaded dirty technologies become obsolete forces consumption to decrease over time, thereby impairing risk-sharing and making green technologies more attractive. We also show that carbon taxes (directed technology subsidies) are more cost-effective when entrepreneurs (financiers) display limited commitment.

Hedging, optimal capital structure and incentives for risk-shifting with preferences for liquidity

We develop a dynamic incomplete-markets model of entrepreneurial firms and demonstrate the implications of preferences for liquidity to entrepreneur's interdependent consumption, portfolio allocation, hedging and financing decisions. The numerical results provide several important implications. Preferences for liquidity reduce hedging demand using risky assets. Besides, the existence of preferences for liquidity decreases the implied equity value and encourages the entrepreneur to issue more debt. Especially, the preferences for liquidity can overturn the risk-shifting incentives of a risk-averse entrepreneur.

Security token offerings versus loan guarantees for risk-averse entrepreneurs under asymmetric information

We compare two competitive financing schemes, loan guarantees and security token offerings (STOs), for a risk-averse entrepreneur to start a project. We show that, if information is symmetric, STOs are better than loan guarantees. Under asymmetric information, we derive the highest equity price that makes low-type entrepreneurs’ imitation unprofitable. If the project risk is sufficiently high, loan guarantees (STOs) induce pooling (separating) equilibrium, and otherwise the opposite holds. Generally the higher the project risk, the less the share of equity retained by entrepreneurs and the less the project value. STOs might make project value increase with project risk. In the view of high-type entrepreneurs, if project risk is not very high or entrepreneurs do not dislike risk too much, loan guarantees are better than STOs, and otherwise the opposite holds true.

Firm asset structure and risk aversion

I study the optimal portfolio choice of risk-averse entrepreneurs in a costly state verification framework. The model generates opposite responses of firm leverage and safe asset share, which are consistent with the empirical evidence. • I study the optimal portfolio choice of risk-averse entrepreneurs in a CSV framework. • Entrepreneurs hold the safe asset even though its return is below the funding cost. • Safe asset share rises with the risk of capital and the risk aversion of entrepreneurs. • Firm leverage and safe asset share move in opposite directions dynamically.

Entrepreneur’s incentives for risk-taking and short-term debt

We investigate the effects of short-term debt for entrepreneur’s incentives for risk-taking. To do so, we develop a model by introducing short-term debt and financing frictions into the entrepreneur framework. The more risk-averse entrepreneur overestimates the liquidity risk and undervalues the private equity, leading to higher incentives for risk-taking. Short-term debt mitigates the risk-shifting problem induced by the entrepreneur’s preference while generating additional risk-taking incentives via rollover risk. We consequently challenge the view of Seta et al. (2020) by predicting a trade-off between the two effects of short-term debt for entrepreneurs, offering a new perspective to harmonize the existing arguments.

Demand risk and diversification through international trade

I develop a theory of risk diversification through geography. In a general equilibrium trade model with monopolistic competition and stochastic demand, risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of their global sales. The model implies that both the probability of entry and trade flows to a country are increasing in the “Diversification Index”, which depends on the multilateral covariance of the country's demand with all other markets. The risk diversification behavior can lead to higher welfare gains from trade than the ones predicted by trade models with risk neutrality. Using a panel of international sales of Portuguese firms, I estimate “risk-augmented” gravity regressions, which show that the Diversification Index significantly affects trade patterns at the extensive and intensive margins. In general equilibrium, the risk diversification channel increases welfare gains from trade by 17% relative to trade models with risk neutrality.

A business case for democracy: regime type, growth, and growth volatility

ABSTRACT I present a business case for democracy, focusing on the impact of democracy on economic growth. This relationship is widely studied, and results have been less robust for growth than many other development outcomes such as literacy or infant mortality. I discuss four factors pertaining to data quality and modelling choices, suggesting that several previous studies have underestimated the growth-benefits of democracy. I further discuss the relationships between democracy and economic crises and variation in economic performance. By mitigating abysmal economic outcomes and ensuring more stable performance, democracy is generally of benefit to risk-averse entrepreneurs, investors, workers, and consumers alike.

The Business Case for Democracy

I present a business case for democracy, focusing on the impact of democracy on economic growth. This relationship is widely studied, and results are less clear for growth than many other development outcomes such as literacy or infant mortality. I discuss four factors pertaining to data quality and modelling choices, suggesting that several previous studies have underestimated the growth-benefits of democracy. I also discuss the relationship between democracy and economic crises and variation in economic performance. By mitigating abysmal economic outcomes and ensuring more stable performance, democracy is generally of benefit to risk-averse entrepreneurs, investors, workers, and consumers alike.

Demand Risk and Diversification through Trade

I develop a theory of risk diversification through geography. In a general equilibrium trade model with monopolistic competition, characterized by stochastic demand, risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of their global sales. I show that the model-consistent measure of demand risk, the “Diversification Index”, depends on the multilateral covariance of a country's demand with all other markets. The model implies that both the probability of entry and the level of trade flows to a market are increasing in the Diversification Index. The firms' risk diversification behavior can generate, upon a trade liberalization, a strong competitive pressure on prices, which in general equilibrium can lead to higher welfare gains from trade than the ones predicted by trade models with risk neutrality. Using a panel of domestic and international sales of Portuguese firms, I estimate “risk-augmented” gravity regressions, which show that the Diversification Index significantly affects trade patterns at the extensive and intensive margins. I quantify that the risk diversification channel increases welfare gains from trade by 16% relative to models with risk neutrality. Finally, the quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent integration of China in the global economy.

Disputes, Debt and Equity

We show how the prospect of disputes over firms’ revenue reports promotes debt financing over equity. These findings are presented within a costly state verification model with a risk averse entrepreneur. The prospect of disputes encourages incentive contracts that limit penalties and avoid stochastic monitoring, even when the lender can commit to stochastic monitoring strategies. Consequently, optimal contracts shift away from equity and toward standard debt. For a useful special case of the model, closed form solutions are presented for leverage and consumption allocations under efficient debt contracts. Some empirical implications of the theory are pursued.

Corporate flat tax reforms and businesses’ investment decisions: evidence from Switzerland

This paper focuses on the effects of a corporate income flat tax reform on businesses’ investment decisions. Since 1990, several Swiss states (cantons) have been switching from a graduated to a flat tax rate scheme on profits. The paper assesses the effects of such a reform both on the number of establishments (i.e. extensive margin of investment) and on the number of employees (i.e. intensive margin) in a given jurisdiction by computing a difference-in-differences estimation. Our results suggest that the introduction of a flat tax reform on corporate income taxes has a negative and statistically significant impact on both margins of investment. Moreover, the effect is considerably larger for riskier firms, suggesting that progressive taxation acts as an insurance effect for risk-averse entrepreneurs.

The financial accelerator and the optimal state-dependent contract

In the financial accelerator literature pioneered by Bernanke et al. (1999) entrepreneurs are myopic and risk-neutral, and loans have a predetermined rate of return by assumption. We relax these assumptions and derive the optimal state-dependent loan contract for forward-looking risk-averse entrepreneurs. We show that financial frictions deliver less amplification under the optimal state-dependent contract.

Entrepreneurs, legal institutions and firm dynamics

This paper assesses the impact of legal institutions on firm dynamics in a model where entrepreneurs have heterogeneous risk aversion, credit constraints and may default. Entrepreneurs choose firm size, capital structure, consumption, default and whether to incorporate. We find that less risk-averse entrepreneurs tend to incorporate while more risk-averse entrepreneurs do not; this occurs because leaving some personal assets exposed by not incorporating allows more risk-averse borrowers to credibly commit to lower default rates. We show that incorporation is determined by two effects: the standard effect that bankruptcy insures low firm returns and a new “scale effect”—more risk-averse entrepreneurs run smaller firms and default more often. The more risk-averse choose to leave some personal assets unshielded in bankruptcy due to a commitment problem that dominates the value of insurance. The less risk-averse run larger firms, default less and incorporate.

Entrepreneurs, Risk Aversion, and Dynamic Firms

How do entrepreneurs vary firm size, capital structure, and default to manage risk? We show that more risk-averse entrepreneurs run smaller, more highly leveraged firms and default less, because running a smaller firm with higher debt reduces personal funds at risk in the firm. Optimal default depends on ex ante debt, consumption forgone from firm liquidation, and owner capacity to inject funds. We show that entrepreneurs sacrifice current consumption in the hope of future success that never materializes for the bottom 25 percent, but entrepreneurship is a path toward great wealth and high consumption for the top quartile.

The Impact of Entrepreneurial Risk Aversion on Wages in General Equilibrium

One of the leading theories of entrepreneurship is that less risk averse individuals become entrepreneurs and more risk averse individuals become their employees. Kihlstrom and Laffont (1979) formalized this insight in an elegant and widely taught general equilibrium model. However, their model has not been further developed. A reason may be that their main comparative static result, that an economy-wide increase in risk aversion lowers the equilibrium wage, appeared to require the assumption that all agents had identical risk aversion index, throwing out their motivating insight and indicating that the model is intractable. In this note we prove this comparative static result on risk aversion and wages in general equilibrium, retaining agent heterogeneity in risk aversion and the endogenous division of agents into less risk averse entrepreneurs and more risk averse workers, without adding any assumptions not already in the original paper. Besides the intrinsic value of the result, we hope to increase the usefulness of the Kihlstrom and Laffont (1979) model for other researchers and to facilitate improvement in its exposition for the many graduate courses in which it is taught.

Optimal Debt Bias in Corporate Income Taxation

I present a rationale for a government to discriminate between debt and equity financing when taxing corporate income. For risk-averse entrepreneurs, equity generates more surplus than debt, because it provides financing and insurance. A government seeking to extract surplus from entrepreneurs would naturally tax equity-generated income more than debt-generated income. I also establish a less obvious reason why the government might want to extract surplus from entrepreneurs. It is well understood that when the quality of projects is unobservable to investors, risk-averse entrepreneurs with higher-return projects might retain a larger share of equity to signal their type (Leland and Pyle (1977)). I show that in such an adverse selection set-ting, while competitive investors are constrained to offer actuarially fair terms, the government can use taxes to discriminate between types. This degree of freedom allows manipulation of the relevant incentive constraints so that a lower level of debt suffices for separation, and an increase in overall efficiency can be obtained. Since entrepreneurs separate along their debt-to-equity ratios, the optimal non-linear tax schedule to achieve the desired discrimination is isomorphic to one that taxes debt-generated income at a lower rate than equity-generated income.

Entrepreneurial finance with equity-for-guarantee swap and idiosyncratic risk

We consider a risk-averse entrepreneur who invests in a project with idiosyncratic risk. In contrast to the literature, we assume the entrepreneur is unable to get a loan from a bank directly because of the low creditability of the entrepreneur and so an innovative financial contract, named equity-for-guarantee swap, is signed among a bank, an insurer, and the entrepreneur. It is shown that the new swap leads to higher leverage, which brings more diversification and tax benefits. The new swap not only solves the problems of financing constraints, but also significantly improves the welfare level of the entrepreneur. The growth of welfare level increases dramatically with risk aversion index and the volatility of idiosyncratic risk.

Optimal Debt Bias in Corporate Income Taxation

I present a rationale for a government to discriminate between debt and equity financing when taxing corporate income. For risk-averse entrepreneurs, equity generates more surplus than debt, because it provides financing and insurance. A government seeking to extract surplus from entrepreneurs would naturally tax equity-generated income more than debt-generated income. I also establish a less obvious reason why the government might want to extract surplus from entrepreneurs. It is well understood that when the quality of projects is unobservable to investors, risk-averse entrepreneurs with higher-return projects might retain a larger share of equity to signal their type (Leland & Pyle (1977)). I show that in such an adverse selection setting, while competitive investors are constrained to offer actuarially fair terms, the government can use taxes to discriminate between types. This degree of freedom allows manipulation of the relevant incentive constraints so that a lower level of debt suffices for separation, and an increase in overall efficiency can be obtained. Since entrepreneurs separate along their debt-to-equity ratios, the optimal non-linear tax schedule to achieve the desired discrimination is isomorphic to one that taxes debt-generated income at a lower rate than equity-generated income.

Entrepreneurial Finance with Equity-for-Guarantee Swap and Idiosyncratic Risk

We consider a risk-averse entrepreneur who invests in a project with idiosyncratic risk and takes debt financing for diversification benefits. In contrast to the literature, we assume the entrepreneur is unable to get a loan from a bank directly because of the low creditability of the entrepreneur and lack of collateral and therefore, an innovative financial contract, named equity-for-guarantee swap, is signed among a bank, an insurer, and the entrepreneur. We build a dynamic incomplete model to investigate the effects of the swap on the entrepreneur's consumption, portfolio, financing and exit from the business. We find that the new swap leads to higher leverage, which brings more diversification and tax benefits. The new swap not only solves the serious problems of widespread financing constraints, but also significantly improves the welfare level of the entrepreneur. The growth of welfare level increases dramatically with risk-aversion index and the volatility of idiosyncratic risk.

Progressive taxes and firm births

Tax reform proposals in the spirit of the “flat tax” model typically aim to reduce three parameters: the average tax burden, the progressivity of the tax schedule, and the complexity of the tax code. We explore the implications of changes in these parameters for entrepreneurial activity, measured by counts of firm births. The Swiss fiscal system offers sufficient intra-national variation in tax codes to allow us to estimate such effects with considerable precision. We find that high average taxes and complicated tax codes depress firm birth rates, while tax progressivity per se promotes firm births. The latter result supports the existence of an insurance effect from progressive corporate income taxes for risk-averse entrepreneurs. However, implied elasticities with respect to the level and complexity of corporate taxes are an order of magnitude larger than elasticities with respect to the progressivity of tax schedules.