Working Paper | HBS Working Paper Series | 2008

Cost of External Finance and Selection into Entrepreneurship

by Ramana Nanda

Abstract

This paper examines the extent to which the positive relationship between personal wealth and entry into entrepreneurship is due to financing constraints. I exploit a tax reform and use unique micro-data from Denmark to study how exogenous changes in the cost of external finance shape both the probability of entering entrepreneurship and the characteristics of those who become entrepreneurs. As expected, differences-in-differences estimates show that the entry rates for individuals who faced an increase in the cost of finance fell by 40% relative to those whose cost of external finance was unchanged. However, while some of the fall in entry was due to less wealthy individuals with high human capital (confirming the presence of financing constraints), the greatest relative decline in entry came from individuals with lower human capital, many of whom were above median wealth. This finding suggests that an important part of the positive relationship between personal wealth and entrepreneurship may be driven by the fact that wealthy individuals with lower ability can start new businesses because they are less likely to face the disciplining effect of external finance.

Keywords: Business Startups; Entrepreneurship; Cost; Financing and Loans; Personal Finance; Human Capital; Wealth; Denmark;

Citation:

Nanda, Ramana. "Cost of External Finance and Selection into Entrepreneurship." Harvard Business School Working Paper, No. 08-047, January 2008.