44 Pages Posted: 7 Apr 2008 Last revised: 3 Feb 2009
Date Written: January 28, 2009
We analyze the nature of financial contracting when an entrepreneur can choose the specificity of investments and financial contracts are incomplete. Investing in project specific assets increases productivity but decreases liquidation value. This creates a strategic incentive to specialize assets to decrease the bargaining power of the financier when debt financing is used. When the financier can contribute to the project, equity financing may be feasible if the entrepreneur is willing to take the firm public in order to make cash flows contractible and benefit from the financier's input. The entrepreneur faces a tension between going public, which is costly but induces the financier to exert effort, and remaining private, which limits the opportunities for contracting but allows the entrepreneur to divert cash flows. We predict that firms with greater opportunity to specialize will be mostly financed by equity, which results in optimal investment and exit decisions.
Keywords: venture capital, bank, incomplete contracts, financial contracts, asset specialization, redeployability, liquidation
JEL Classification: G21, G24, G32
Suggested Citation: Suggested Citation
Marquez, Robert and Yavuz, M. Deniz, Financial Contracting and the Specialization of Assets (January 28, 2009). Available at SSRN: https://ssrn.com/abstract=1116420 or http://dx.doi.org/10.2139/ssrn.1116420