Why Are Entrepreneurs Liquidity-Constrained?

Why are entrepreneurs liquidity-constrained? The existing literature has almost exclusively focused on incentive problems associated with choices of work efforts and of project qualities. This paper shifts attention to the effect of liquidity-constraints on the quality of the entrepreneurial pool. Assuming that entrepreneurial ability is private information while personal wealth is public information, the paper shows that entrepreneurs are liquidity-constrained because the critical ability for one to choose being an entrepreneur rather than a wage worker increases with his personal wealth and therefore markets read low wealth of a would-be entrepreneur as a signal of low entrepreneurial ability and high probability of default. A normative implication is that liquidity constraints may be socially desirable since they work as a mechanism to guarantee that only high-ability people will be selected for entrepreneurship.