Liquidity constraint theory of entrepreneurship
Liquidity Constraints Theory: Does Money Buy Entrepreneurship?
There is an old saying: "It takes money to make money." In academic terms, this is known as Liquidity Constraints Theory.
The theory posits a simple but powerful relationship: founding a new venture is significantly more common among individuals with greater access to financial capital. Because borrowing money for a high-risk startup is difficult and expensive, personal wealth becomes the primary gateway to entrepreneurship.
The Wealth Advantage
Evans and Jovanovic (1989) provided the foundational research for this theory. They found that wealthier individuals are more likely to enter entrepreneurship simply because they can risk their own capital without relying on skeptical banks or investors.
This creates a barrier to entry: talented but poor individuals are "constrained" from starting businesses, while perhaps less talented but wealthy individuals are free to try.
Liquidity Events as Triggers
Where does this wealth come from? Often, it comes from previous employment.
Stuart and Sorenson (2003) found evidence that many employees make the leap to entrepreneurship immediately following "Liquidity Events"—such as Initial Public Offerings (IPOs) or acquisitions of their parent firms.
These events put significant cash into the hands of employees holding stock options. Now flush with cash, these employees gain the financial freedom to spin out new ventures, creating a cycle of innovation in wealthy clusters like Silicon Valley.
The Counter-Argument: Entry vs. Growth
However, the theory is not without critics. Hurst and Lusardi (2004) argue that liquidity constraints might be exaggerated. They found that the correlation between wealth and startup entry only exists at the very top of the wealth distribution.
This suggests a nuance: Money might not be required to start (Entry), but it is required to scale (Growth).
- Entry Phase: Davidsson and Honig (2003) point out that starting a business does not necessarily require significant resources. Theories like Bricolage (making do with what you have) and Effectuation explain how founders launch with zero capital.
- Growth Phase: However, scaling requires efficiency and economies of scale, which demand heavy capital investment. Davila et al. (2003) found that ventures receiving VC funds grow employees and equity value much faster than those that do not.
Modern Implications: Crowdfunding and ICOs
Recent developments in Crowdfunding and Initial Coin Offerings (ICOs) are testing this theory in real-time. By making large pools of capital available to the masses, these tools theoretically remove liquidity constraints.
If the theory holds true, crowdfunded startups should vastly outperform bootstrapped ones due to their ability to scale early. However, the jury is still out. While capital provides a runway, it does not guarantee product-market fit.
Video: Financing the New Venture
References
Davidsson, P., & Honig, B. (2003). The role of social and human capital among nascent entrepreneurs. Journal of Business Venturing, 18(3), 301-331.
Davila, A., Foster, G., & Gupta, M. (2003). Venture capital financing and the growth of startup firms. Journal of Business Venturing, 18(6), 689-708.
Evans, D. S., & Jovanovic, B. (1989). An estimated model of entrepreneurial choice under liquidity constraints. Journal of Political Economy, 97(4), 808-827.
Hurst, E., & Lusardi, A. (2004). Liquidity constraints, household wealth, and entrepreneurship. Journal of Political Economy, 112(2), 319-347.
Stuart, T., & Sorenson, O. (2003). Liquidity Events and the Geographic Distribution of Entrepreneurial Activity. Administrative Science Quarterly, 48(2), 175.
