Entrepreneurial Finance and Non-diversifiable Risk

Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incompletemarkets 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. Non-diversifiable risks have several important implications: (1) more risk-averse entrepreneurs default earlier, but optimaly 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.