"Does Lack of Liquidity Impair Entrepreneurs?"

Who's right, Smith or Plato?:

Does lack of liquidity impair entrepreneurs?, by Hans K. Hvide, Vox EU: One of the oldest ideas in the study of entrepreneurship is that entrepreneurs may be unable to establish a venture at an efficient scale due to liquidity-constraints arising from capital market imperfections. This idea can be traced back to Adam Smith, who in the Wealth of Nations stated that entrepreneurs: "have all the knowledge, in short, that is necessary for a great merchant, which nothing hinders him from becoming but the want of sufficient capital."

Business people and venture capitalists, on the other hand, caution that excess liquidity can facilitate overspending or adversely affect the entrepreneur’s motivation to perform. The idea that more liquidity can have a negative effect on performance can be traced back to Plato, who in the Republic wrote: "wealth is the parent of luxury and indolence". Who should we place our bets on, Adam Smith or Plato?

Previous work tends to focus on whether lack of liquidity stops nascent entrepreneurs from starting up a company. The findings here are mixed. While early research such as Evans and Jovanovic (1989) tends to find that start-up propensity is correlated with wealth, recent work on US data by Hurst and Lusardi (2004) finds practically no relation. The question then is whether lack of liquidity can have effects on other, perhaps more important, aspects of entrepreneurship, such as size and profitability.

Using a unique dataset from Norway, our research investigates the effect of liquidity, as measured by founder's prior wealth, on start-up size and start-up profitability. To avoid capturing effects that go via more wealthy founders having higher human capital, we control for human capital via age, education, and prior wage variables. We also control for business cycle and industry effects.

The following figure uses the estimated coefficients to plot predicted start-up size and predicted profitability for varying wealth levels.

The dashed line depicts the predicted start-up size as a function of the founder’s prior wealth. Size is measured in log Norwegian kroner (NOK) value of assets at the end of the first year of operations (1EUR=8NOK). Liquidity has a rather strong effect on size. For example, the predicted start-up size for an entrepreneur with wealth around NOK 5,000,000 is about twice the predicted start-up size for a founder that has wealth of just NOK 500,000. The positive relation between founder wealth and start-up size suggests that, consistent with Smith’s view, liquidity constraints are important in determining venture size.

The solid line depicts the relationship between wealth and profitability, as measured by operating return on assets. Profitability increases by about 8 percentage points from the 10th to the 75th wealth percentile. This suggests an entrepreneurial production function with a region of increasing returns, and that liquidity constraints could stop entrepreneurs from being able to exploit a "hump" in marginal productivity.

At the top of the wealth distribution, profitability drops by about 11 percentage points from the 75th to the 99th percentile. That profitability decreases on some interval of the wealth distribution is what one would expect if marginal profitability decreases as start-ups reach their efficient scale, as in Evans and Jovanovic (1989). It is puzzling, however, that profitability on assets falls sharply in the region where entrepreneurs are least likely to be liquidity-constrained.

One explanation for why the relation between wealth and profitability decreases sharply at the top could be that richer founders are more indolent and less dedicated to their venture. We find evidence consistent with this view. While 85% of the entrepreneurs in the bottom 95% of the wealth distribution work for the start-up at the end of the second year of operations, the corresponding figure for the entrepreneurs in the top 5% is only 68%.

We also investigate the relation between founder prior wealth and other measures of performance such as entrepreneurial wage and survival. Our results here are broadly consistent with the results obtained on profitability.

Overall, our findings thus give support to both Adam Smith and Plato. A moderate amount of liquidity may propel entrepreneurial performance, consistent with Smith’s view, but an abundance of it may do more harm than good, consistent with Plato’s view.

Borrow and moral hazard As an alternative explanation to increasing returns, the upward-sloping part of the dashed curve could be because more wealthy entrepreneurs borrow less than less wealthy entrepreneurs and are thus less exposed to moral hazard, as in Aghion and Bolton (1997) thus ensuing better performance. We investigated this possibility by analysing the relationship between founder prior wealth and the level of debt of the start-up at the end of the first year. As argued by Paulson et al. (2006), one would expect this relationship to be negative if the underlying reason for liquidity constraints is moral hazard, while if the underlying reason for liquidity constraints is limited liability, as in Evans and Jovanovic (1989), one would expect it to be positive. The estimates we obtained suggested a strong positive relation between wealth and the level of debt in all wealth groups, with an elasticity of debt to wealth of about 0.3. Thus the role of moral hazard in explaining the upward-sloping part of the solid line in the figure seems limited, and increasing returns to scale seems the more likely explanation.

Policy implications We see two main policy implications. For a main bulk of the wealth distribution, liquidity constraints incur a large negative effect on start-up size and profitability. This suggests a possible role for policy in alleviating financial constraints of young businesses. Obviously, such policies may have pitfalls of their own. For example, policies aimed towards improving the liquidity of start-ups could have a detrimental effect on the selection into entrepreneurship, a question our study does not address. Second, we find a sharply negative relation between liquidity and profitability at the top of the wealth distribution. This suggests that policies aimed at alleviating liquidity constraints should carefully target those entrepreneurs that are indeed likely to be liquidity-constrained.

Comments

[paine]

here lies much mischief and much magic

conjecture :

posit a pure credit based entrepreneurial system

with polycentric credit suppliers
result

massive increase in innovation

[ken melvin]

Not sure credits role in 'entrpreneuring'. In the early days of a start up it's beg steal or borrow. Once on line, or with enough to show promise, the money comes from investors via stocks, venture capital, etc. At this point, the offers are often ridiculess.

[spencer]

At the peak of the 1990s LBO boom many of the tech start-ups were essentially operating at zero cost of capital.

Is this an example of what we are talking about?

[robertdfeinman]

The industrial age is over. It is being replaced by the information age. It is not clear that the models of raising capital that worked in the former age are suitable in the new era.

In the past one would set up a factory and use capital to buy equipment. If the enterprise failed, the creditors had some idea of how much they could recoup by selling off the assets. This gave a fairly good estimation of the risk involved.

Now enterprises are founded on the strength of ideas. If Google were to go bankrupt I doubt that more than 1-2% of its valuation would be recaptured by selling off its tangible assets. The situation is even more complex when the firms involved are in financial services. Even if the instruments they deal in could be priced appropriately at one moment in time, there is no way of predicting what they will be worth at some point in the future. We have seen the first case of the repercussions of the lack of suitable models unfolding at present with the melt down in the credit markets.

The second aspect of the new age is that entrepreneurship now means something new. So does innovation. When an inventor came to a bank with his design for a new widget there were those who could evaluate the profit potential of the innovation. The dot com bubble showed how hard it is to do the same thing with ideas. Is delivering pet food to the home a good idea? It seemed so at the time.

Perhaps, I'm just old fashioned, but I don't think treating the creation of new financial instruments and other intangible ideas should be measured the same way as widgets. I think this means that we are seeing less "real" entrepreneurship and innovation and more of something which still doesn't have a name.

I don't think this is a good thing. South Sea bubbles are never a good way to run an economy.

[Bruce Wilder]

I would wonder what the downside risk is -- what is the risk of failure?

A common practice among venture capitalists is to make the entrepreneur mortgage everything to the hilt, so that if the business venture fails, the entrepreneur fails.

Clearly, as wealth scales up, liquidity and the ability to fully fund the venture scales up as well, probably enhancing the chance of success. But, it is not clear how this affects the downside risk. If you are rich enough, you are insured against failure, even of a large venture -- for a passive investor, that can be a good thing -- ask the managers of the Yale endowment how an infinite horizon combine with big pots of money to enable high returns.

But, the active investor, the entrepreneur, should not be allowed to diversify or insure himself. His job is to watch the basket, so you want all his eggs in that basket.

By the way, this same principle applies to CEO salaries. A key indicator that typical options and bonus packages are not performance-based incentives, as claimed, is that they typically have no down-side risk.

[Meh]

Bruce, whilst I agree with you up to a point (you need downside risk to avoid moral hazard) the high failure rate of many VC's has been tied in some studies to the overwhelming downside risk placed on the entrepreneur.

It handily sorts out the kind of people who don't care if their entire life goes up in smoke tomorrow, but that isn't necessarily the kind of people who actually produce innovation (or even profits) on a consistent basis.

We've pumped up the notion of the heroic entrepreneur far beyond the evidence and in doing so, created a self-fulfilling prophecy where only the psychopathic would rationally be attracted to entrepreneurship.

[S Brennan]

Having started a manufacturing business and knowing others in Canada and Europe who have done the same I can assure you the cost to US is higher.

In the US all medical and social services are born by start-up Businesses and it's employees, this not the case elsewhere.

Build a decent safety net and you will have more entrepreneurs starting business.

[gc]

Is it wrong to consider the meaning you draw from these studies together with the general distributions of wealth in our society? It seems that the general distribution of wealth has been skewing toward a greatly increased wealthy elite at the expense of a substantially impoverished middle class. Could this correspond with a concentration of assets in the hands of individuals whose entrepreneurial judgments are poor, while leaving the middle class counterparts restrained from adequately financing their projects?

[Bruce Wilder]

"Could this correspond with a concentration of assets in the hands of individuals whose entrepreneurial judgments are poor, while leaving the middle class counterparts restrained from adequately financing their projects?"

Sort of a metaphor for George W. Bush v. the Democrats in Congress?

[cm]

Bruce Wilder: With the risk of merely repeating Meh, too much (perceived) downside risk leads to too much risk aversion, effectively keeping qualified individuals from taking the first step.

[Bruce Wilder]

Risk is a difficult topic, because "objective" measures and clear, quantitative concepts are unavailable to help us express clearly how risk shapes the incentive to control production processes with investment and management.

I am inclined to think that the most general set of cases would suggest that the best human decision-making is well-insured decision-making. It is not wise to make people either frightened or desperate, if such can be avoided with proper institutions of social cooperation. Unfortunately, in the absence of such institutions, people with a lot of excess capacity for risk-bearing (i.e. very wealthy people) can make a lot of money off of frightened and desperate people. When I listen to conservative libertarians arguing for "smaller government" I hear little toads croaking to make the world safer for the rich and ruthless to exploit. That's a big part of my political outlook.

So, naturally, I am very sympathetic to the remarks of several commenters about the danger of downside risk bringing about undesirable risk aversion or even selection for psychopaths.

The most general case, however, is not every case.

The entrepreneur is not the only one taking a risk in working for a new venture; every employee takes on some risk. What Brennan said strikes me as very important in this respect. Better social insurance makes it much easier for people to take those risks.

With regard to what Meh said about selection for psychopaths, I have said similar things about how skyrocketing CEO compensation perversely affects the tournament to become a CEO, CEO tenure and the like. One factor in CEO compensation is that CEOs belong to a kind of club, that selects its own members. The rules in place make it very difficult for stockholders to organize effectively to select boards of directors; even very large shareholders and investment funds are inhibited from exercising their power and boards of directors are often selected, in practice, by the CEO.

The case of the wealthy enterpreneur self-financing a venture and the case of an entrepreneur seeking venture-capital financing are quite different from each other and from the typical situation of the non-wealthy individual dependent on labor income.

Venture-capitalists select both the ventures and the entrepreneurs, and usually quite carefully. I don't see much danger of psychopaths self-selecting themselves to receive venture-capital financing. (That's not to say that there weren't some psychos grabbing venture capital financing in the dotcom boom, when VC went nutz.)

With regard to VC-financed enterprise, structuring considerable down-side risk into the entreneur's "incentive package" is very sensible. The entrepreneur is deprived of insurance, and subject to risk aversion, it is true, but he's also been given tremendous power (and presumably selected for the ability to wield that power effectively). Generally, one wants the powerful to be appropriately risk-averse with regard to the exercise of their power.

We're not talking (I hope) about taking away the entrepreneur's insurance against things he cannot powerfully affect -- like, say, the chance his wife gets cancer. That would be pretty perverse: a VC saying, "you cannot have health insurance until this business is in positive cashflow."

Anyway, I appreciated the remarks, and wish I had the language to make clearer distinctions about risk, but I don't.

[Bill]

Let's not forget that when a would-be entrepreneur leaves behind a steady job, that creates a fair bit of downside risk in and of itself.

[cm]

Bruce Wilder: In a society like ours, where pretty much everything is intermediated through money, your money or future earning prospects become the single basket holding all eggs. Impacting that means impacting all the risk-taker's risks. And we don't want to underestimate "downward mobility" as a considerable risk factor that occurs with social insurance too. When it comes to careers, downward tends to be quite sticky. Companies generally prefer people whose careers have been trending up, and having to step down jobwise in a desperate move for any reason will generally terminate a career.

After that long speech, my point is really discriminating between different classes of risk does not convince me a lot.

Of course, that's not to say letting innovators off the hook is a prerequisite to innovation. But giving them some breaks certainly helps in enabling some directions of research that are not dead sure from the outset. Of course, the "90% garbage" rule applies.