Entrepreneurial finance and non-diversifiable risk. NBER Working Paper No

Preliminary Version Entrepreneurs face significant non-diversifiable idiosyncratic business risks. In a dynamic incomplete-markets model of entrepreneurial finance, we show that such risks have important implications for their interdependent consumption/saving, portfolio choice, financing, invest-ment, and endogenous default/cash-out decisions. Even though more risk-averse entrepreneurs default earlier for given debt service, they choose higher leverage ex ante for diversification ben-efits. Entrepreneurs demand not only a systematic risk premium but also an idiosyncratic risk premium due to the lack of diversification. We derive an analytical formula for the idiosyncratic risk premium whose key determinants are risk aversion, idiosyncratic volatility and the sensitiv-ity of entrepreneurial value of equity with respect to cash flow. An entrepreneur’s option to use external equity in the future increases his diversification benefits and private value of firm, but crowds out/lowers the value of diversification via external risky debt. When an entrepreneur chooses one of mutually exclusive projects with different idiosyncratic volatilities after debt is in place, the effect of risk aversion may dominate the risk-shifting incentives. Only entrepreneurs with a low level of risk aversion engage in risk shifting activities