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2011 | Book

Advances in Entrepreneurial Finance

With Applications from Behavioral Finance and Economics

Author: Rassoul Yazdipour

Publisher: Springer New York

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About this book

Advances in Entrepreneurial Finance brings together contributions from researchers from the fields of entrepreneurship, behavioral finance, psychology, and neuroscience to shed new light on the dynamics of decision making and risk taking by entrepreneurs and venture capitalists (VCs). Every new venture requires access to capital at competitive interest rates, and much has been written on general entrepreneurship by management scholars and financial contracting by financial economists using traditional finance theory with all its highly restrictive assumptions regarding decision makers’ cognitive capabilities and behavior. But recent developments in behavioral finance can now be applied to understand how entrepreneurs and VCs perceive risk and uncertainty and how they decide and act accordingly. Showcasing the latest research, this volume demonstrates that findings from the behavioral and neuroscience arenas can and do explain decision making by entrepreneurs and venture investors in the real world. Consequently, such findings have practical implications not only for entrepreneurs, venture capitalists, and their advisors, but also all government agencies and NGOs that want to support product and technological innovation, capital formation, job creation, and economic development.

Table of Contents

Frontmatter
Chapter 1. Introduction
Abstract
I ran across Baumol’s famous statement as brought in above for the very first time almost 25 years ago. That thought not only stayed with me over the years, but it probably, and possibly subconsciously, might have even helped trigger the launching­ of the Academy of Entrepreneurial Finance 3 years later and the publication of the Advances in Small Business Finance (Yazdipour 1991) around the same time. So Baumol’s point was a natural opener for this section; except for the fact that given the subtitle of the book – behavioral finance – it needed some added element. For this, I visited NASA’s Knowledge Management site to see if I could improve upon the quotation; and there I saw Alan Kay’s “It’s the people, stupid.” But that was telling the same thing except for saying it more emphatically. Then I remembered Herbert A. Simon’s characterization of the version of economic rationality that he refers to as the Olympian model and then goes on to define it as a model that “… serves, perhaps, as a model of the mind of …, but certainly not as a model of the mind of man” (Simon 1983). And that is exactly what I was looking for: economic rationality does not serve as a model of the mind of man!
Rassoul Yazdipour

THEORETICAL FOUNDATION

Chapter 2. A Behavioral Finance Approach to Decision Making in Entrepreneurial Finance
Abstract
Three central decisions in entrepreneurship and entrepreneurial finance – entry/seed funding, financing/investment, and growth/exit – are discussed and case is made for applying the behavioral finance theories and concepts to better understand the involved decision processes, and consequently, to help improve the decision-making process for both entrepreneurs and venture capitalists. The behavioral finance approach is important because the traditional finance has remained silent on the first issue, and the Agency Theory (financial contracting), which is effectively the only theory that is applicable to issues in entrepreneurial finance, has produced mixed empirical results. (See for example Bitler et al. [Bitler MP, Moskowitz T J, Vissing-Jorgensen A (2009) Why do entrepreneurs hold large ownership shares? Testing agency theory using entrepreneur effort and wealth. Working Paper. Graduate School of Business, University of Chicago].) Attempts are also made in this chapter to introduce some new concepts – “Perception Asymmetry,” “Resident Risk,” and a preliminary behavioral risk framework – that as complements to the existing constructs could be used in discussions on decision making under risk and uncertainty. Although the focus is on individual decision making under highly uncertain entrepreneurial environments, the suggested risk framework and the related discussions can be extended to decision making in other uncertain environments.
Rassoul Yazdipour
Chapter 3. Beyond Agency Theory: Value Creation and the Role of Cognition in the Relationship Between Entrepreneurs and Venture Capitalists
Abstract
This chapter explores entrepreneur–investor relations from a cognitive perspective. I show that entrepreneurs’ and investors’ specific mindsets matter for the perception and realization of strategic opportunity. Differences in cognitive structure and process thus influence value creation beyond economizing on agency costs. I define and add concepts of cognitive cost and cognitive value to a basic agency model, which allows me to explain why some entrepreneur–investor relations create more value than others, although they may have the same level of agency costs. This enhanced framework also helps understand why external funding may not be available to certain ventures, even if agency conflicts can be kept under control through proper incentive alignment. The concepts of cognitive cost and value are shown to be especially relevant in the context of entrepreneurial finance, where uncertainty is typically high, and knowledge about value creation opportunities is ambiguous. An investor’s appreciation of the value of entrepreneurs’ knowledge about strategic opportunity depends on the closeness of their respective mindsets. Some investor types such as venture capitalists (VCs) share certain of the entrepreneurs’ mental features and develop specific skills to identify valuable ventures at a low cognitive cost while adding cognitive value through strategic advice and mentoring, especially when entrepreneurs are still inexperienced.
Peter Wirtz
Chapter 4. Financial Risk Perceptions: A Behavioral Perspective
Abstract
The generally accepted financial risk metrics, such as variance and Beta, are axiomatic mathematical constructions. They have mathematical validity but can be questioned on behavioral grounds. This chapter suggests a broader alternative approach. First, perception involves experiential content acquired as a result of human/world interaction. It is not merely the product of a passive internal “brain process.” Second, financial risk is hypothesized to be primarily a perception of potential loss as fabricated by an evolutionary dual decision-making process that embraces both affect and formal cognitive analysis. Thus of necessity, perceptions of risk contain both cognitive and affective attributes. Because man is by nature a social creature, perceived risk also entails risk attributes that manifest group concerns. These hypotheses are supported by a comprehensive literature review. Evidence is presented suggesting that this alternative perspective parsimoniously explains many current “risk/return” market anomalies.
Robert A. Olsen
Chapter 5. Contribution of Neuroscience to Financial Decision-Making
Abstract
The apparent limitations of rational decision-making have become increasingly important phenomena that are unexplained by traditional economic models. Initial research found that these anomalies were not just random deviations from normative models, but actually, systematic physiologically driven psychological processes. Behavioral Finance and Economics that emerged as biopsychological fields began to explain how people actually use information when making financial decisions. In the past, behavioral economic research has relied on extrapolation. Choice could only be inferred from observed outcomes through behavior. Recently, neuroscience, as powered by in-vivo brain imaging and our understanding of brain biology, has allowed scientists to more directly examine the internal landscape of decision-making. A literature review of applied clinical neuroscience and neuroeconomics yields a new perspective on decision-making – one that is driven by objective data. These data are generated by means of newly developed tools. However, these tools come with well-defined strengths and weaknesses. Understanding the technological constraints is critical to appropriate data interpretation and future model building. This review addresses two different and independent brain operations: the reflexive automatic process and the reflective deliberate process. The meso-limbic and meso-cortical systems, which underlie each operation, are essential to understanding decision-making in the light of the emotional, learning, memory, and executive processes involved in decision-making. A significant amount of work has been devoted to studies of the neurotransmitter system involving Dopamine (DA). Dopamine seems to emerge as a key player in decision-making due to the association it holds with reward, attention, motivation, and error assessment brain processes. In addition, DA, in concert with other neurotransmitters and neuro-modulators, influences affective states that play a significant role in regulating physiological and psychological homeostasis. An individual’s intrinsic processes that are genetically influenced and modulated to regulate homeostasis will consequently impact acute sensitivities as related to rewards and punishments. Thus, the threshold and tolerance for reward and punishment are strongly associated with the decision-making. In line with the growing body of neuroeconomic research, this review presents the neuroscientific underpinnings of information processing and decision-making. The conclusions are not about the rational decision model being wrong, but rather about its potential limitations in light of new biologically driven data.
Richard W. Ackley, Lukasz M. Konopka
Chapter 6. Uncertainty Is Psychologically Uncomfortable: A Theoretic Framework for Studying Judgments and Decision Making Under Uncertainty and Risk
Abstract
A novel theoretic framework for examining judgments under uncertainty and risk is proposed based on literature examining how decision makers subjectively represent the concept of uncertainty, and how that representation influences the decision-making process. The literature suggests that “uncertainty” is conceptualized differently than is implied from the perspective of formal models such as the expected utility model. The literature further suggests that strategies used to cope with uncertainty are contingent upon how uncertainty is conceptualized, and also suggests that both cognitive and affective components of the decision influence how information is processed during decision making. The theoretic framework presented in this chapter postulates that uncertainty creates a state of psychological discomfort that motivates the decision maker to move the decision situation from a state of uncertainty toward a state of certainty in order to reduce the discomfort created by uncertainty, and ultimately, to make a decision. Given uncertainty is the main characteristic of an entrepreneurial environment, the present chapter has direct implications for both entrepreneurs and venture capitalists. Both theoretic and practical implications for future research suggested by the theoretic framework are outlined.
William P. Neace, Kate Deer, Steven Michaud, Lauren Bolling

ISSUES IN FINANCING STARTUPS AND SMALL FIRMS

Chapter 7. The Changing Landscape of Small-Firm Finance
Abstract
This chapter reflects on the changes in financing small firms during the past 25 years by reviewing the extant literature on how small businesses are financed at their inception, how continuing operations are financed, and how changing technologies have shaped capital markets for small firms. Our review of a unique small firm time series data set shows that many of the obstacles small firms faced in the early 1980s have mostly disappeared. New firm formations continue to depend on owner savings, friends, and family, while venture capital remains a microscopic proportion of total new firm financing in any given year. Once operating, small firms depend primarily on banks for operating support and capital investment, but the use of credit cards (business and personal) and nonbank sources (finance/leasing companies) is increasing in importance. We end with a discussion of two current issues in small firm finance: the cumulative impact of banking consolidation in the USA and the effect of the current financial crisis in the USA on small firm access to capital.
William Dunkelberg, Jonathan A. Scott
Chapter 8. Applications of Behavioral Finance to Entrepreneurs and Venture Capitalists: Decision Making Under Risk and Uncertainty in Futures and Options Markets
Abstract
A key dimension of entrepreneurship is risk-taking behavior, and often it is assumed that entrepreneurs exhibit a higher tolerance for risk than non-entrepreneurs. However, empirical evidence provides mixed findings, raising the question whether entrepreneur’s judgment is influenced by emotion and heuristics which leads them to misperceive the risk in the market. Our findings support this idea. Empirical results indicate these investors generally take more risk than would be anticipated. Higher risk propensity is due to probability weighting and is also consistent with the idea that entrepreneurs and possible venture capitalists perceive risky situations more optimistically than non-entrepreneurs.
Fabio Mattos, Philip Garcia
Chapter 9. Insights into the Psychological Profiles of Entrepreneurs
Abstract
Entrepreneurs derive lower risk-adjusted returns than non-entrepreneurs, but are compensated through non-pecuniary benefits. This chapter reports on findings from survey evidence. The main findings are as follows: A key non-pecuniary benefit to entrepreneurs is achieving greater control over their working environment. Doing so leads entrepreneurs to report achieving higher affect and well-being than non-entrepreneurs. Entrepreneurs report that they are more skilled socially than non-entrepreneurs. This might provide a partial explanation for why entrepreneurs have a higher marriage rate and larger families than non-entrepreneurs. Entrepreneurs exhibit greater dispositional optimism than non-entrepreneurs. However, in the study sample, the difference is not statistically significant. In terms of preference for lottery-like outcomes, entrepreneurs find prospects offering high returns with low probability attractive, but regard control of their environment as more important than the preference for positive skewness.
Hersh Shefrin

ISSUES IN GROWTH AND BEYOND

Chapter 10. Firm Failure Prediction Models: A Critique and a Review of Recent Developments
Abstract
This chapter first argues that the literature on financial distress and failure prediction has totally ignored the cause of failure – managers and owner-managers as decision makers – and instead has almost exclusively focused on the effect of failure, the financial data. The chapter then provides a review of the current state of the failure prediction literature. Recent studies that focus on small and medium-sized enterprises (SMEs) are covered next. We arrive at the same conclusion that after 35 years of academic inquiry into bankruptcy prediction, and despite all the sophisticated models and methodologies used in studies of the effects of firm failure, there is “no academic consensus as to the most useful method for ­predicting corporate bankruptcy.” At the end, the chapter discusses how psychological ­phenomena and principles, also known as heuristics or mental shortcuts, might be utilized in building more powerful success/failure prediction models.
Richard L. Constand, Rassoul Yazdipour
Chapter 11. The Evolution of Entrepreneurs and Venture Capitalists
Abstract
We have evolved “as if” reproduction is the sole goal for which human beings were “designed,” and everything else is a means to that end. However, natural selection is a slow process, and Homo sapiens originated about 200,000 years ago, so our minds today are adapted to maximize gene replication in the Pleistocene. Meanwhile, an investor seeking to maximize wealth, Homo economicus, should behave according to expected utility theory. Aspects of the behavior of Homo sapiens that differ from Homo economicus include the endowment effect, loss aversion, risk aversion, overconfidence, optimism, the representativeness heuristic, the availability heuristic and herding. This chapter speculates how these heuristics and biases may have evolved, and focuses on their effect on entrepreneurs and venture capitalists.
Martin Sewell
Chapter 12. Statistical Databases for Research on the Financing of Small and Start-Up Firms in the United States: An Update and Review
Abstract
Academic and policy makers’ interest in start-up business financing originated from two areas of concern – capital requirements for a start-up and the availability of external sources of private financing for a start-up. The former is important because underestimation of capital requirements has been mentioned by most small business management professional as one of the most critical deficiencies in start-up planning affecting the prospect for success or survival of a start-up (Studies on “new firm creation” using the Panel Study Entrepreneur Dynamics (PSED) data concluded that majority of nascent entrepreneurial start-ups failed to become operational businesses (Reynolds 2007).) Many nascent entrepreneurs have lost their lifetime savings in starting a business by being overly optimistic about the time and the resources it takes to develop and operate a viable business. The amount of capital required relative to the availability of internal resources will determine the need for external sources of capital. (Internal resources include monetary resources such as personal savings, other income (from the spouse as well), personal credit lines, as well non-monetary resources such as an office/work place at home, office equipment and telecommunication facilities, and personal transportation.) Unavailability of external sources of financing from private capital markets has been blamed for the high failure rate among start-ups.
This chapter updates information about the databases available for researchers in conducting financial research on small and startup firms. Three major databases on startup financing are discussed in detail, including comments on the strengths and weaknesses of each of the three major databases regarding their uses for conducting different types of research. It is followed by a review of major data sources for small firm financing, including time-series information, on activities in specific financing markets for small firms.
Charles Ou
Backmatter
Metadata
Title
Advances in Entrepreneurial Finance
Author
Rassoul Yazdipour
Copyright Year
2011
Publisher
Springer New York
Electronic ISBN
978-1-4419-7527-0
Print ISBN
978-1-4419-7526-3
DOI
https://doi.org/10.1007/978-1-4419-7527-0