Risk Sharing, Risk Taking and Effort Provision

Using lab experiments this paper examines how the risk and return characteristics of a venture along with an entrepreneur’s effort provision in it are affected by whether the venture is funded by a debt or an equity contract. In our experiments participants are sorted into groups where they make decisions as entrepreneurs and investors in ventures financed through debt and equity. We find that ventures financed through equity have significantly higher risk and higher expected returns as compared to debt financed ventures. We argue that the higher risk taking behaviour may be explained by the risk structure of equity contracts which is positively correlated across the investor and entrepreneur. We also find that entrepreneurs perceive the risk structure of equity contracts to be more fair. This leads to entrepreneurs with a stronger preference for fairness to take a higher risk in equity ventures