Financing Entrepreneurial Production: Security Design with Flexible Information Acquisition

Abstract

We propose a theory of security design in financing entrepreneurial production, positing that the investor can acquire costly information on the entrepreneur’s project before making the financing decision. When the entrepreneur has enough bargaining power in security design, the optimal security helps incentivize both efficient information acquisition and then efficient financing. Debt is optimal when information is not very valuable for production, while the combination of debt and equity is optimal when information is valuable. If instead the investor has sufficiently strong bargaining power in security design or can acquire information only after financing, equity is optimal.

Keywords: security design, debt, combination of debt and equity, flexible information acquisition

JEL Classification: D82, D86, G24, G32, L26