The relationship between an entrepreneur and an external investor, like a bank or a venture
capital investor, is a popular topic in academic literature. When these two parties negotiate the
conditions of their cooperation, they particularly have to agree on the distribution of state
dependent profits and losses. Because there is a wide range of forms of external financing,
there are plenty of ways to share profits and losses.
This article focuses on the question: What influences the risk allocation between an
entrepreneur and an investor? There is a major difference in the risk allocation of debt
financing, for example, by taking out a bank loan, and equity financing, such as selling stocks.
In the case of insolvency and liquidation of a company, claims of outside investors owning
debt are treated preferentially while investors owning equity only have residual claims.
Because entrepreneurs are typically owners of internal equity, the use of external debt implies
a different risk allocation between an entrepreneur and an investor than the use of external
However the resulting risk allocation does not just vary between debt and equity contracts.
For example, a bank loan with high collateral implies different risk allocation than a bank
loan without any collateral. But the topic of this article is neither the exact distinction between
equity and debt contracts nor distinction between debt contracts with high and low collateral.
The goal of this article is to tackle the topic of risk allocation in a general and abstract
In practice, contracts imposing most of the financial risks on entrepreneurs are in the majority.
Mishkin (2007) shows, that the lion's share of external finance is covered by debt contracts,
usually accompanied by collateral1
. Thus you can find these contracts much more often than
contracts implying a more equal split of risks.
Investigation in to the reasons for the observed one-sided risk allocation of financial contracts
in academic literature will reveal various theories following one line of argumentation -
asymmetric information. In the standard financial economics textbook of Mishkin (2007),
asymmetric information between investors and entrepreneurs is named as the decisive reason
for the rare use of equity contracts and intensive use of collateral2
. The main argument is thus:
Entrepreneurs are assumed to have an informational advantage compared to investors as well
as some scope for unobservable action. To ensure that entrepreneurs do not use their
informational advantage to take excessive risks, you have to impose the financial risks of their
behavior on them. So to avoid the classical problems of asymmetric information, such as
adverse selection and moral hazard, contracts are chosen that impose the risks on the
entrepreneur. In practice, this takes the form of an intensive use of debt contracts and
Another example is an article by Gersbach and Uhlig (2006). In their model, a monopolistic
informational disadvantaged bank offers equity contracts, while in a competitive market only
debt contracts survive3
. Their result relies on the assumption that 'good' entrepreneurs strictly
prefer debt contracts, while 'shirkers' are indifferent between debt and equity contracts.
Argumentation by Bester (1985, 1987) is similar. In his signaling model, banks are faced with
two types of entrepreneurs, 'good' and 'bad', depending on the riskiness of their projects.
Because a bank cannot observe an entrepreneur's type, it tries to reveal their types by offering
separating contracts. In this model, good entrepreneurs choose a contract with relatively high
collateral, while bad entrepreneurs choose a contract with less collateral but higher interest 2
. Both approaches create the impression that a one-sided risk allocation is not due to the
malpractice of a bank, but a privilege reserved for good entrepreneurs.
Several other academic articles describe one sided risk allocation between entrepreneurs and
investors as a result of efficiency considerations under asymmetric information - this point of
view is criticized here. A fundamental weakness of this popular point of view is that it
remains unclear what would have been the outcome in the absence of asymmetric
information. Only if the contracts offered under symmetric information differ essentially from
the contracts offered under asymmetric information, can informational asymmetries be the
main reason for the resulting contracts. The question tackled here is thus: Which contracts
would be offered under symmetric information?
Because asymmetric information is present in reality without a doubt, one cannot answer that
question by looking at empirical data from banks or venture capitalists - but controlled
laboratory experiments provide the opportunity to get closer to an answer. In laboratory
experiments it is possible to choose assumptions, eliminating adverse selection as well as
moral hazard. But this experiment does not seek to reproduce reality more accurately than in
the criticized theoretical models. Instead of the experiment seeks to provide a robustness
check of finance theories based on asymmetric information
Source: Essay UK - http://buystrangestuff.com/free-essays/economics/risk-allocation.php
If this essay isn't quite what you're looking for, why not order your own custom Economics essay, dissertation or piece of coursework that answers your exact question? There are UK writers just like me on hand, waiting to help you. Each of us is qualified to a high level in our area of expertise, and we can write you a fully researched, fully referenced complete original answer to your essay question. Just complete our simple order form and you could have your customised Economics work in your email box, in as little as 3 hours.
This Economics essay was submitted to us by a student in order to help you with your studies.
This page has approximately words.
If you use part of this page in your own work, you need to provide a citation, as follows:
Essay UK, Risk Allocation Between An Entrepreneur And An Investor. Available from: <http://buystrangestuff.com/free-essays/economics/risk-allocation.php> [21-03-18].
If you are the original author of this content and no longer wish to have it published on our website then please click on the link below to request removal: