The Burden of the Nondiversifiable Risk of Entrepreneurship

Robert Hall () and Susan E. Woodward

No 14219, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G12 G24 G32 H1 L14 (search for similar items in EconPapers)
Date: 2008-08
New Economics Papers: this item is included in nep-ent
Note: EFG ME
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Citations: View citations in EconPapers (3)

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.

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