The Impact of Owners and Policy on Small Firms

How important are differences in owner personal characteristics (risk tolerance or optimism) versus the environment in which a firm operates (bankruptcy institutions or access to credit) for firm financial structure, size, owner net-worth and welfare? To answer this question we construct a dynamic, computable model with heterogeneous agents and endogenous default in which entrepreneurs weigh the firm’s current and future returns. We find that modest differences in risk aversion match SSBF data, and the environment in which a firm operates matters greatly. The option to declare bankruptcy insures an owner against extreme current loss and the ability to bail out the firm with personal funds preserves the potential for high future gains. We find that welfare gains from bankruptcy reform or improved access to credit are substantial, especially for agents most willing to bear risk. Risk aversion also affects firm legal status: we show that incorporation always leads to higher welfare for less risk averse entrepreneurs while the more risk averse may have higher welfare by remaining unincorporated. The more risk averse cannot credibly commit ex-ante to refrain from default ex post; having some personal assets that would be seized in bankruptcy mitigates this problem. In contrast, the firms of the less risk averse are larger and have higher future value, which credibly limits their incentive to default. JEL Classification Numbers: D92, E01, G33, G38, L25, L26