The view of informal employment as a last resort in the labour market has recently been challenged by numerous studies documenting the existence of a high degree of heterogeneity within the formal and informal sectors - in particular the presence of high-tier informal work corresponding to voluntary self-employment. There is currently not much theoretical support for these observations. We develop a formal model to explain this growing empirical evidence about substantial heterogeneity within formal/informal labour markets. In our model, workers may enter self-employment or search for jobs as employees, while allowing for heterogeneity across workers’ managerial ability. While workers with higher managerial ability will manage larger firms, workers with lower managerial ability will manage smaller firms and be in self-employment only when they cannot find a salaried formal/informal job. For the latter, self-employment in the informal sector is the outside employment option.