Entrepreneurs, legal institutions and firm dynamics

This paper assesses the impact of legal institutions on firm dynamics in a model where entrepreneurs have heterogeneous risk aversion, credit constraints and may default. Entrepreneurs choose firm size, capital structure, consumption, default and whether to incorporate. We find that less risk-averse entrepreneurs tend to incorporate while more risk-averse entrepreneurs do not; this occurs because leaving some personal assets exposed by not incorporating allows more risk-averse borrowers to credibly commit to lower default rates. We show that incorporation is determined by two effects: the standard effect that bankruptcy insures low firm returns and a new “scale effect”—more risk-averse entrepreneurs run smaller firms and default more often. The more risk-averse choose to leave some personal assets unshielded in bankruptcy due to a commitment problem that dominates the value of insurance. The less risk-averse run larger firms, default less and incorporate.