This post comes to us from Robert E. Hall
of Stanford University and the National Bureau of Economic Research, and Susan E. Woodward
of Sand Hill Econometrics, Inc.
An entrepreneur’s primary incentive is ownership of a substantial share of the enterprise that commercializes the entrepreneur’s ideas. An inescapable consequence of this incentive is the entrepreneur’s exposure to the idiosyncratic risk of the enterprise. Diversification or insurance to ameliorate the risk would necessarily weaken the incentives for success. In our forthcoming American Economic Review paper, The Burden of the Nondiversifiable Risk of Entrepreneurship, we study this issue in the case of startup companies backed by venture capital.
We make use of a rich body of data, which we believe is not a sample, but close to the universe of companies receiving venture funding from 1987 to the present. Standard venture deals involve three parties: entrepreneurs, general partners, and limited partners. The entrepreneurs have leveraged positions; that is, they receive no payoff until other claimants have received prescribed payoffs. The general partners, who arrange financing and supervise the startup company by holding board seats, are compensated in proportion to the amount invested and the capital gains on the investment. The limited partners are passive investors who hold debt and equity claims on the startup. General partners are somewhat diversified across investments and the limited partners are highly diversified. The burden of specialization falls mainly on the entrepreneurs.
We focus on the joint distribution of the duration of the entrepreneur’s involvement in a startup what we call the venture lifetime and the value that the entrepreneur receives when the company exits the venture portfolio. Exits take three forms: (1) an initial public offering, in which the entrepreneur receives liquid publicly-traded shares or cash (if she sells her own shares at the IPO or soon after) and has the opportunity to diversify; (2) the sale of the company to an acquirer, in which the entrepreneur receives cash or publicly-traded shares in the acquiring company and has the opportunity to diversify; and (3) shutdown or other determination that the entrepreneur’s equity interest has essentially no value. Most IPOs return substantial value to an entrepreneur. Some acquisitions also return substantial value, while others may deliver a meager or zero value to the entrepreneur. The joint distribution shows a distinct negative correlation between exit value and venture lifetime. Highly successful products tend to result in IPOs or acquisitions at high values relatively quickly.
In addition, we develop a unified analysis of the factors affecting the entrepreneur’s risk-adjusted payoff, based on a dynamic program. The analysis takes account of the joint distribution of exit value and venture lifetime and of salary and compensation income. We use it to calculate the certainty-equivalent value of the entrepreneurial opportunity the amount that a prospective entrepreneur would be willing to pay to become a founder of a venture-backed startup. For a risk-neutral individual, the certainty-equivalent is $3.6 million. With mild risk aversion and savings of $100,000, however, the amount is only $0.7 million and with normal risk aversion and that amount of savings, the certainty-equivalent is slightly negative.
Our most important finding is that the reward to the entrepreneurs who provide the ideas and long hours of hard work in these startups is zero in almost three quarters of the outcomes, and small on average once idiosyncratic risk is taken into consideration.
The full paper is available for download here.