Dynamics of entrepreneurship under incomplete markets. Working paper

An entrepreneur faces substantial non-diversifiable business risk and liquidity con-straints. We provide an analytically tractable dynamic incomplete-markets framework in which to study the entrepreneur’s interdependent business start-up, capital accumu-lation/asset sales, portfolio allocation, consumption, and business exit decisions. We show that business risks and liquidity constraints have economically significant effects. The entrepreneur invests substantially less in his business than an otherwise identical public firm does. Non-diversifiable idiosyncratic risk and liquidity constraints give rise to precautionary demand and cause the marginal value of wealth to be greater than unity. The investment decisions for an entrepreneurial firm differ fundamentally from those for public firms as in standard q theories of investment. The exit option provides flexibility and insurance to the entrepreneur. Moreover, it generates a convexity ef-fect of volatility on business investment and portfolio choice. The entrepreneur’s entry decision depends on his outside option, the fixed start-up cost and the endogenously determined marginal value of wealth under incomplete markets. We also provide a