Liquidity and Risk Management: Coordinating Investment and Compensation Policies

We study the corporate finance implications of risky inalienable human capital for a risk-averse entrepreneur. We show how liquidity and risk management policies coordinate investment and executive compensation policies to efficiently retain managerial talent and honor corporate liabilities. The firm optimally balances the goal of attaining mean-variance efficiency for the entrepreneur's net worth and that of preserving financial slack. The former is the main consideration when the firm is flush with liquidity and the latter is the only consideration when the firm has depleted its financial slack. We show that relative to the first-best, the entrepreneur's net worth is over-exposed to idiosyncratic risk and under-exposed to systematic risk. These distortions are greater the more financially constrained the firm is.