Retained Equity, Investment Decisions and Private Information

Abstract:     
This paper considers an optimal contracting problem between an informed risk-averse agent and a set of risk averse principals. An informed entrepreneur approaches a group of outside investors to sell them an equity share in the firm motivated by risk-sharing gains. In contrast to the Leland and Pyle (1977) model I give the bargaining power to the outside investors and I assume that, on top of the risk-allocation decision, the investors and the entrepreneur also negotiate over a real investment decision in the firm. It is shown that the introduction of this investment decision may destroy the main qualitative implication of the Leland and Pyle model: the quantity retained by the entrepreneur may not be increasing in his private information. The model's results point to potential specification problems in empirical studies trying to confirm the Leland-Pyle hypothesis, and more generally endogeneity problems that may arise when testing adverse-selection hypotheses based on one-dimensional problems when the parties can use multi-dimensional mechanisms. A new set of empirical predictions on the relation between retained equity and investment and firm characteristics is also discussed.

Keywords: Retained Equity, Mechanism Design, Multi-dimensional Screening

JEL Classifications: D82, G32

Working Paper Series