Testing Agency Theory With Entrepreneur Effort and Wealth

We develop a principal-agent model in an entrepreneurial setting and test the model's predictions using unique data on entrepreneurial effort and wealth in privately held firms. Accounting for unobserved firm heterogeneity using instrumental-variable techniques, we find that entrepreneurial ownership shares increase with outside wealth and decrease with firm risk; effort increases with ownership; and effort increases firm performance, supporting the model's predictions. The magnitude of the effects in the cross-section of firms suggests that agency theory may help explain why entrepreneurs concentrate large fractions of their wealth in firm equity.