Entrepreneurs who found new firms tend to work as employees in small rather than large firms prior to start-up and have previous experience of entrepreneurship. We provide a model of self-selection based on heterogeneous risk preferences which can explain these stylized facts.

Simon Parker

English

Research Papers in Economics

Which firms do the entrepreneurs come from? 
Simon Parker
Durham University
Abstract
Entrepreneurs who found new firms tend to work as employees in small rather than large
firms prior to start-up and have previous experience of entrepreneurship. We provide a model
of self-selection based on heterogeneous risk preferences which can explain these stylized
facts.
Citation: Parker, Simon, (2007) "Which firms do the entrepreneurs come from?." Economics Bulletin, Vol. 10, No. 10 pp. 1-9
Submitted: May 18, 2007.  Accepted: August 2, 2007.
URL: http://economicsbulletin.vanderbilt.edu/2007/volume10/EB-07J20003A.pdf1. Introduction
Recent research has shown that entrepreneurs who found new ￿rms tend
to work as employees of small rather than large ￿rms prior to start-up (Boden,
1996; Wagner, 2004), and to have had previous experience of entrepreneur-
ship (Evans and Leighton, 1989; van Praag and van Ophem, 1995). While a
possible explanation of the ￿rst of these facts is that small ￿rms have a com-
parative advantage in furnishing their employees with productive experience
which is conducive to entrepreneurship, there is presently no direct evidence
demonstrating this to be the case. Nor is it the only possible explanation:
this article explores an alternative one, whereby individuals possess di⁄er-
ent degrees of risk aversion, with less risk-averse individuals self-selecting into
small ￿rms and entrepreneurship at di⁄erent stages of their lives.1 As we will
show, this explanation tallies with both of the stylised facts outlined above,
without requiring strong assumptions about technology and skills. And, by
proposing a new theory of the entrepreneurship-￿rm size relationship, the
prospect of a lively future empirical research agenda emerges.
Section 2 sets up the model, and Section 3 uses it to derive a sequence of
results regarding the sorting of workers between large and small ￿rms, and the
identities of the workers who become entrepreneurs. Section 4 concludes with
a very brief sketch of how empirical researchers might test the new theory
against the alternative one of productive experience conveyed by small ￿rms.
2. The Model: Assumptions and Notation
The economy comprises three types of ￿rm: ￿ large￿ , ￿ small￿ , and ￿ outside￿ .
These three types are discrete and have the following characteristics. Large
￿rms are protected by entry barriers, so neither small ￿rm owners nor their
employees can become large ￿rms. Occupational choice between being a small
1Kihlstrom and La⁄ont (1979) were the ￿rst to recognise that less risk-averse individuals
would prefer risky entrepreneurship to less risk-averse entrepreneurship, but they did not
explore the ￿rm-size/entry issue.
1￿rm owner and a worker is limited by the existence of product niches. Each
small ￿rmowner pro￿tably exploits one and only one niche. The total number
of niches is initially ￿xed, preventing entry into small ￿rms; later on we study
occupational choice when the number of niches increases exogenously.2 Large
￿rms maximize expected returns, either because they are risk neutral or
because they are fully diversi￿ed. In contrast, small ￿rm owners and workers
are risk averse and maximize expected utility, having utility functions U(x;r),
where x is the (possibly state-dependent) payo⁄ and r indexes risk aversion
(see below). The third type of ￿rm, called ￿ outside ￿rms￿ , o⁄ers workers a
￿xed wage w > 0.
Workers produce output in a single period by exerting contractible e⁄ort
(an assumption that can be relaxed ￿ see below) and produce a high level
of output S with a common exogenous probability ￿ 2 [0;1] and a low level
of output S with probability 1 ￿ ￿, where S > S > 0. Owners receive the
output and remunerate workers with transfers, derived below, denoted by
t￿ if they are state-independent, and by (t
￿;t￿) if they are state-dependent.
More workers just scale up ￿rm owners￿total output, so a worker can always
match with an owner. All actors have complete information apart from future
realizations of ~ S 2 fS;Sg. To make the problem interesting, we assume that
small business owners cannot perfectly smooth their incomes via a stock
market or comprehensive income insurance ￿ as observed in practice.
There are two types of worker in the economy, who di⁄er only in terms
of their risk aversion; in all other respects they are identical. The type of
a worker is indexed by r, where r 2 f￿;￿g. Workers with r = ￿ > ￿ have
greater risk aversion than workers with r = ￿. We will write the transfers
received by workers of a given type by t￿
r [or (t
￿
r;t￿
r)]. The owners of small
￿rms have risk aversion ￿ > 0. Denote by  r a worker r￿ s expected utility
from the next best alternative occupation to being a worker in their chosen
￿rm; the values of the f rg are endogenous and will be derived below.
Two ￿nal assumptions rank the payo⁄s from being owners or workers.
First we stipulate
A1 : S ￿ t
￿
r > S ￿ t
￿
r ￿ t
￿
r ￿ t
￿
r for each r:
Thus net pro￿ts from being a ￿rm owner in the good state exceed those in the
bad state, which in turn exceed worker￿ s wages in the good state.3 Second,
2Niches could alternatively be replaced with a market imperfection such as borrowing
constraints, in which only the richest and least risk-averse individuals have access to and
a preference for entrepreneurship. While this would generate qualitatively similar results,
the advantage of constructing a model with niches rather than borrowing constraints is
that one can abstract from secondary issues related to credit markets.
3In fact, this assumption is stronger than we need, which is that all individuals receive
2we assume that
A2 : ￿ = minf￿;￿g = ￿;
i.e., small ￿rm owners are as risk averse as the least risk-averse worker. Given
A1, assumption A2 ensures that the expected utility of being an owner is
unambiguously higher than that of a worker: i.e., entrepreneurial niches are
valuable.
3. The Model: Assumptions and Notation
The ￿rst two parts of this section focus on the allocation of workers to
￿rms when the number of product niches is ￿xed. The third part establishes
which ￿rms generate the entrepreneurs when the number of niches increases.
3.1 O⁄ered contracts
The small ￿rm owner designs a contract for agents with risk aversion r
that solves the following problem:
max
f(tr;tr)g
￿U(S ￿ tr;￿) + (1 ￿ ￿)U(S ￿ tr;￿) (1)
s.t. ￿U(tr;r) + (1 ￿ ￿)U(tr;r) ￿  r (2)
where (1) is the expected utility of the owner and (2) is worker r￿ s partici-
pation constraint.
Let ￿ denote the Lagrange multiplier for this concave programming prob-
lem. The ￿rst order conditions are:
￿￿U
0(S ￿ t
￿
r;￿) + ￿￿U
0(t
￿
r;r) = 0 (3)
￿(1 ￿ ￿)U
0(S ￿ t
￿
r;￿) + ￿(1 ￿ ￿)U
0(t
￿
r;r) = 0 (4)
From (3) and (4) it follows that
￿ =
U0(S ￿ t
￿
r;￿)
U0(t
￿
r;r)
=
U0(S ￿ t￿
r;￿)
U0(t￿
r;r)
> 0 (5)
U0(t
￿
r;r)
U0(t￿
r;r)
=
U0(S ￿ t
￿
r;￿)
U0(S ￿ t￿
r;￿)
(6)
It follows from (5) that the constraint (2) binds and can be imposed as an
equality below. However, the trial solution t
￿
r = t￿
r does not allow (5) to hold
with equality, so we must have t
￿
r > t￿
r. Hence there is incomplete insurance
unambiguously higher expected payo⁄s as an owner than as a worker. That ensures there
will be market entry (i.e., entrepreneurship) when the number niches expands.
3across states for both small ￿rm owners and workers. In contrast, the risk-
neutral large ￿rm owner optimally sets t
￿
r = t￿
r = t￿
r, i.e., they completely
insure their workers.
3.2 Allocation of workers to ￿rms
Next we study the participation constraints in greater detail and derive
an equilibrium allocation of workers to ￿rms. Recall that there are two types
of worker (￿ and ￿) and three types of ￿rm (small ￿ with risk averse owners;
large ￿ with risk neutral owners; and outside ￿ o⁄ering a ￿xed wage w).
Suppose to start with that the less risk-averse ￿ types are employed by small
￿rms, while the more risk-averse ￿ types are employed by large ￿rms, so we
can de￿ne two compensation contracts ￿￿ := (t
￿
￿;t￿
￿) and ￿￿ := t￿
￿. Consider
a deviation from this rule, whereby ￿ types covet the contract ￿￿. This
contract would have to satisfy
EU(￿￿;￿) ￿ U(￿￿;￿); (7)
where E is the expectations operator. As ￿ > ￿, it follows using (6) that
U0(t
￿
￿;￿)
U0(t￿
￿;￿)
<
U0(t
￿
￿;￿)
U0(t￿
￿;￿)
=
U0(S ￿ t
￿
￿;￿)
U0(S ￿ t￿
￿;￿)
(8)
￿￿ is not optimal for ￿ types because it o⁄ers them too little insurance: (7)
cannot hold. But an alternative contract ￿￿
￿ := (t
￿
￿;t￿
￿) such that EU(￿￿
￿ ;￿) ￿
U(￿￿;￿) must have t
￿
￿ < t
￿
￿ and t￿
￿ > t￿
￿, because of the greater concavity
of the utility function of ￿ types. However, risk-averse small ￿rm owners
will not accept this because EU(~ S ￿￿￿
￿ ;￿) < EU(~ S ￿￿￿;￿): i.e., the alter-
native contract that suits ￿ types leaves the small ￿rm owners bearing too
much risk. Hence the contracts sought by ￿ types in small ￿rms are always
dominated by the contracts that ￿ types would take.
Would ￿ types want to deviate from the contract ￿￿? Large ￿rm owners
have the incentive to reduce ￿￿ until the participation constraint (2) holds
with equality for ￿s: i.e., until U(￿￿;￿) =  ￿ = EU(￿￿;￿). Because ￿ < ￿
) EU(￿￿;￿) > EU(￿￿;￿), it follows that4
EU(￿￿;￿) > U(￿￿;￿); (9)
i.e., ￿ types will not covet the other contract, ￿￿. Finally, consider a contract
t￿
￿ that ￿ types would ￿nd acceptable in large ￿rms. This would have to
satisfy
EU(￿￿;￿) ￿ U(t
￿
￿;￿) (10)
4Strictly speaking, the inequality in (9) requires only marginal di⁄erences in risk aver-
sion between the types such that U(x;￿) ￿ U(x;￿) for any certain payo⁄ x.
4But by comparing (9) and (10), this requires t￿
￿ > t￿
￿. Hence the contracts
sought by ￿ types in large ￿rms are always dominated (outbid) by the con-
tracts that ￿ types would take.
This establishes that ￿ types match with small ￿rms and receive ￿￿,
while ￿ types match with large ￿rms and receive ￿￿. To complete the char-
acterization of equilibrium, notice that by o⁄ering w > 0, the outside ￿rm
enables large ￿rm owners to force t￿
￿ down as far as, but no further than, w,
so  ￿ = U(w;￿). Thus ￿s receive ￿￿ = t￿
￿ = w from large ￿rm owners, and
are indi⁄erent between working for a large or an outside ￿rm. Likewise for
￿ types the equality EU(￿￿;￿) =  ￿ = U(w;￿) together with (3) and (4)
determine (￿￿;￿), where t
￿
￿ > t￿
￿ > t￿
￿. This constitutes a competitive sepa-
rating equilibrium because none of the owners or workers has any incentive
to deviate from it.
Finally, we note that this separating equilibrium is robust to introducing
non-contractible worker e⁄ort into the model. A formal analysis of this moral
hazard problem is provided by Parker (2006): the basic logic of the solution is
that both small and large ￿rm owners must make wages more variable when
e⁄ort is non-contractible in order to elicit high levels of e⁄ort from their
workers. However, small ￿rm owners still provide less insurance to their
workers than large ￿rm owners do, so once again, less risk-averse workers
match with small ￿rm owners (principals). Thus our matching results are
robust to this extension of the model.
3.3 Which ￿rms do entrepreneurs come from?
When a new niche becomes available, all workers have the opportunity
to set up a ￿rm in an attempt to establish the dominant ￿rm in the niche.
Competition ensures that the dominant ￿rm is drawn from among the set
of entrepreneurs with the lowest costs. To determine the characteristics of
the lowest cost entrepreneurs, suppose ￿rst that the potential entrant has
relatively high risk aversion of ￿ > ￿. For these individuals
U0(t
￿
￿;￿)
U0(t￿
￿;￿)
=
U0(S ￿ t
￿
￿;￿)
U0(S ￿ t￿
￿;￿)
>
U0(S ￿ t
￿
￿;￿)
U0(S ￿ t￿
￿;￿)
: (11)
Analogous to (8), to equate the ￿rst and third terms of (11) it is necessary to
change the transfers from ￿￿ to something else. Denote the transfers o⁄ered
to ￿ workers by owners with risk aversion ￿ by ￿￿￿ = (t
￿
￿￿;t￿
￿￿), to distinguish
them from those (namely ￿￿) o⁄ered by owners with risk aversion ￿ < ￿.
Then it follows that t
￿
￿￿ > t
￿
￿ and t￿
￿￿ < t￿
￿. But then EU(￿￿;￿) > EU(￿￿￿;￿)
for all risk averse ￿ workers. Hence no ￿ workers would work for ￿ owners:
all would prefer to work for ￿ owners. E⁄ectively, ￿ owners ask their workers
5to bear an unacceptable amount of risk compared with what is available
elsewhere. The only way that a ￿ individual could attract workers is by
incorporating a risk premium into the contract; but this makes them a higher
cost producer than a ￿ type.
Hence for new entrants to compete they must have risk aversion ￿ ￿ ￿.
From A2 earlier ￿ = ￿ < ￿, so if new niches are to be exploited at all,
￿ = ￿ = ￿. Clearly, ￿ types are lower cost producers in the new niche
than ￿ types are, since ￿ types do not have to pay their workers the risk
premium that ￿ types do; hence the new entrepreneurs are the less risk-
averse ￿ types, who have the same risk attitudes as incumbent small ￿rm
owners.5 These ￿ types have already sorted themselves into small ￿rms, as
established earlier: hence small ￿rms generate the entrepreneurs, as observed
empirically by previous researchers (Boden, 1996; Wagner, 2004).
The foregoing logic can also be used to predict that if the number of
niches declines, the entrepreneurs who exit return to work as employees in
small ￿rms. So if the number of entrepreneurial opportunities then expanded
again, these workers, with experience of business ownership ￿ but more
fundamentally, with low risk aversion ￿ are more likely to re-enter business
ownership than workers without this experience (which includes employees
of large ￿rms). Hence one would expect to observe a positive association
between previous experience of entrepreneurship and the likelihood of entry
into entrepreneurship ￿ even in the absence of any productivity-enhancing
bene￿t from experience. Numerous previous empirical studies have detected
an association of this kind (Evans and Leighton, 1989; van Praag and van
Ophem, 1995).
4. Future research
This article has proposed a new self-selection theory about where entre-
preneurs come from. Empirical research is now needed to test the theory
against alternative explanations, including one based on the idea that small
￿rms have a comparative advantage in furnishing their employees with pro-
ductive experience which is conducive to entrepreneurship.
The data needed to test the competing theories is a panel survey which
elicits responses about worker, ￿rm and job characteristics from a random
sample of respondents. Panel data are necessary in order to track employees
observed to work in small or large ￿rms in one period making transitions into
entrepreneurship subsequently. Binary choice econometric models can then
be used to test the self-selection hypothesis by estimating whether personal
5The prediction that less risk-averse individuals are likelier to become entrepreneurs
accords with a growing body of empirical evidence (van Praag et al, 2002; Ekelund et al,
2005).
6characteristics associated with risk attitudes (e.g., responses to hypothetical
gambling questions as in PSID 1996 or risky lifestyle choices as in Brown et al,
2006) are signi￿cantly related to transitions to entrepreneurship. Likewise,
the hypothesis that small ￿rms promote entrepreneurship by giving their
employees useful experience can be tested by checking whether transitions
to entrepreneurship are related to job characteristics including measures of
experience, exposure to customers, diverse job tasks and length of job tenure.
If the hypothesis that small ￿rms transmit experience is correct, one would
expect these job characteristics when interacted with indicator variables for
small ￿rm status to be signi￿cantly positively related to entrepreneurship
transitions. Performing tests of this kind represent the ￿rst steps of an ex-
citing new research agenda.
7References
Boden, R. J. (1996) Gender and self-employment selection: an empirical
assessment, Journal of Socioeconomics, 25, pp. 671￿ 82.
Brown, S., L. Farrell, M. N. Harris and J. G. Sessions (2006) Risk preference
and employment contract type, Journal of the Royal Statistical Society,
Series A, 169(4), pp. 849￿ 63.
Ekelund, J., Johansson, E., Jarvelin, M-J., and D. Lichtermann (2005) Self-
employment and risk aversion ￿ Evidence from psychological test data,
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Evans, D. S. and L. S. Leighton (1989) Some empirical aspects of entrepre-
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Praag, C. M. van and H. van Ophem (1995) Determinants of willingness and
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8

Which firms do the entrepreneurs come from?

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Which firms do the entrepreneurs come from?

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