Does lack of liquidity impair entrepreneurs?

Hans Hvide

28 September 2007



One of the oldest ideas in the study of entrepreneurship is that entrepreneurs may be unable to establish a venture at an efficient scale due to liquidity-constraints arising from capital market imperfections. This idea can be traced back to Adam Smith, who in the Wealth of Nations stated that entrepreneurs: "have all the knowledge, in short, that is necessary for a great merchant, which nothing hinders him from becoming but the want of sufficient capital."

Business people and venture capitalists, on the other hand, caution that excess liquidity can facilitate overspending or adversely affect the entrepreneur’s motivation to perform. The idea that more liquidity can have a negative effect on performance can be traced back to Plato, who in the Republic wrote that ”wealth is the parent of luxury and indolence”. Who should we place our bets on, Adam Smith or Plato?

Previous work tends to focus on whether lack of liquidity stops nascent entrepreneurs from starting up a company. The findings here are mixed. While early research such as Evans and Jovanovic (1989) tends to find that start-up propensity is correlated with wealth, recent work on US data by Hurst and Lusardi (2004) finds practically no relation. The question then is whether lack of liquidity can have effects on other, perhaps more important, aspects of entrepreneurship, such as size and profitability.

Using a unique dataset from Norway, our research investigates the effect of liquidity, as measured by founder's prior wealth, on start-up size and start-up profitability. To avoid capturing effects that go via more wealthy founders having higher human capital, we control for human capital via age, education, and prior wage variables. We also control for business cycle and industry effects.

The following figure uses the estimated coefficients to plot predicted start-up size and predicted profitability for varying wealth levels.

The dashed line depicts the predicted start-up size as a function of the founder’s prior wealth. Size is measured in log Norwegian kroner (NOK) value of assets at the end of the first year of operations (1EUR=8NOK). Liquidity has a rather strong effect on size. For example, the predicted start-up size for an entrepreneur with wealth around NOK 5,000,000 is about twice the predicted start-up size for a founder that has wealth of just NOK 500,000. The positive relation between founder wealth and start-up size suggests that, consistent with Smith’s view, liquidity constraints are important in determining venture size.

The solid line depicts the relationship between wealth and profitability, as measured by operating return on assets. Profitability increases by about 8 percentage points from the 10th to the 75th wealth percentile. This suggests an entrepreneurial production function with a region of increasing returns, and that liquidity constraints could stop entrepreneurs from being able to exploit a "hump" in marginal productivity.

At the top of the wealth distribution, profitability drops by about 11 percentage points from the 75th to the 99th percentile. That profitability decreases on some interval of the wealth distribution is what one would expect if marginal profitability decreases as start-ups reach their efficient scale, as in Evans and Jovanovic (1989). It is puzzling, however, that profitability on assets falls sharply in the region where entrepreneurs are least likely to be liquidity-constrained.

One explanation for why the relation between wealth and profitability decreases sharply at the top could be that richer founders are more indolent and less dedicated to their venture. We find evidence consistent with this view. While 85% of the entrepreneurs in the bottom 95% of the wealth distribution work for the start-up at the end of the second year of operations, the corresponding figure for the entrepreneurs in the top 5% is only 68%.

We also investigate the relation between founder prior wealth and other measures of performance such as entrepreneurial wage and survival. Our results here are broadly consistent with the results obtained on profitability.

Overall, our findings thus give support to both Adam Smith and Plato. A moderate amount of liquidity may propel entrepreneurial performance, consistent with Smith’s view, but an abundance of it may do more harm than good, consistent with Plato’s view.

Moral hazard rather than increasing returns?

As an alternative explanation to increasing returns, the upward-sloping part of the solid line could be because more wealthy entrepreneurs borrow less than less wealthy entrepreneurs and are thus less exposed to moral hazard, as in Aghion and Bolton (1997) thus ensuing better performance. We investigated this possibility by analysing the relationship between founder prior wealth and the level of debt of the start-up at the end of the first year. As argued by Paulson et al. (2006), one would expect this relationship to be negative if the underlying reason for liquidity constraints is moral hazard, while if the underlying reason for liquidity constraints is limited liability, as in Evans and Jovanovic (1989), one would expect it to be positive. The estimates we obtained suggested a strong positive relation between wealth and the level of debt in all wealth groups, with an elasticity of debt to wealth of about 0.3. Thus the role of moral hazard in explaining the upward-sloping part of the solid line in the figure seems limited, and increasing returns to scale seems the more likely explanation.

Policy implications

We see two main policy implications. For a main bulk of the wealth distribution, liquidity constraints incur a large negative effect on start-up size and profitability. This suggests a possible role for policy in alleviating financial constraints of young businesses. Obviously, such policies may have pitfalls of their own. For example, policies aimed towards improving the liquidity of start-ups could have a detrimental effect on the selection into entrepreneurship, a question our study does not address. Second, we find a sharply negative relation between liquidity and profitability at the top of the wealth distribution. This suggests that policies aimed at alleviating liquidity constraints should carefully target those entrepreneurs that are indeed likely to be liquidity-constrained.


Aghion & Bolton (1997). A Theory of Trickle-Down Growth and Development. Review of Economic Studies, 59, 151-72.
Evans, D. S. & B. Jovanovic (1989). An Estimated Model of Entrepreneurial Choice under Liquidity Constraints. Journal of Political Economy, 97, 8-8-27.
Hurst, E. & A. Lusardi (2004). Liquidity Constraints, Household Wealth, and Entrepreneurship. Journal of Political Economy, 112, 319-47.
Paulson, A., R. M. Townsend & A. Karaivanov (2006). Distinguishing Limited Liability from Moral Hazard in a Model of Entrepreneurship. Journal of Political Economy, 114, 100-144.



Topics:  Financial markets Labour markets

Tags:  entrepreneurship, liquidity, start-up size and profitability

Professor of Economics and Finance, University of Bergen and CEPR Research Affiliate