Saturday, November 29, 2008

An argument for being a salaried drone

The big rewards [to entrepreneurship] come only to those whose companies go public or are acquired on favorable terms, forcing entrepreneurs to bear a substantial burden of idiosyncratic risk. We study this burden in the case of high-tech companies funded by venture capital. Over the past 20 years, the typical venture-backed entrepreneur earned an average of $4.4 million from companies that succeeded in attracting venture funding. Entrepreneurs with a coefficient of relative risk aversion of two and with less than $0.7 million would be better off in a salaried position than in a startup, despite the prospect of an average personal payoff of $4.4 million and the possibility of payoffs over $1 billion. We conclude that startups attract entrepreneurs with lower risk aversion, higher initial assets, preferences for entrepreneurship over employment, and optimistic beliefs about the payoffs from their products.
--Robert Hall and Susan E. Woodward, "The Burden of the Nondiversifiable Risk of Entrepreneurship," NBER Working Paper 14219


JW said...

Hello, is it possible to describe what "coefficient of relative risk aversion of two" means in an everyday setting? How could I get an idea of what my value would be, if that's even possible?

James Choi said...

Suppose you are faced with a 50-50 gamble. You will either get $50,000 per year for the rest of your life, or $100,000 per year for the rest of your life. You will have no other source of income for the rest of your life.

What guaranteed consumption stream would make you just as happy as if you faced the above gamble? It depends on your relative risk aversion:

RRA = 0: $75,000
RRA = 1: $70,711
RRA = 3: $63,246
RRA = 5: $58,566
RRA = 10: $53,991
RRA = 20: $51,858
RRA = 30: $51,209

JW said...

Thank you so much!