Capital Structure and Moral Hazard within Entrepreneurial Firms

This paper tests agency theory using unique entrepreneurial effort and financing choices data. Focusing on entrepreneurs as a special type of agent, the paper develops a modified principal-agent model within a private firm setting. In line with the typical agency theory prediction, this model suggests that the severity of entrepreneur moral hazard relates to the firm’s capital structure. Specially, the model predicts that the entrepreneurial effort is negatively related to equity and debt financing, and higher firm risk leads to greater entrepreneurial effort reductions. Accounting for both observable and unobservable firm and entrepreneur heterogeneities, empirical tests find supportive evidence for all these predictions. ∗Assistant Professor, School of Business & Economics, Wilfrid Laurier University, Waterloo, Ontario, N2L 3C5. Phone: 519-884-0710 ext. 2925. Fax: 519-888-1015. E-mail:[email protected]. The author gratefully acknowledges that financial support for this research was received from a grant partly funded by WLU operating funds and partly by the SSHRC institutional Grant awarded to WLU.