Optimal Security Design under Asymmetric Information and Profit Manipulation

Abstract

We consider a model of external financing in which privately informed entrepreneurs seek funds from competitive financiers. The literature restricts attention to monotonic securities and finds that straight debt is the uniquely optimal. Monotonicity is justified by the argument that it would arise endogenously if the entrepreneur can window dress the realized earnings. We explicitly characterize the optimal contracts when entrepreneurs can manipulate output, and derive necessary and sufficient conditions for debt to be optimal. Contrary to conventional wisdom, debt is often suboptimal and it is never uniquely optimal. Optimal contracts are non-monotonic and induce profit manipulation in equilibrium.

Keywords: Security design, financial innovation, capital structure, asymmetric information, venture capital

JEL Classification: D82; D86; G32; M40