Optimal Financial Contracts for a Start-Up with Unlimited Operating Discretion

Abstract

This paper presents a model in which asymmetric information and extreme uncertainty lead to the exclusive use of equity and riskless debt for small business financing. The paper derives these results without any restrictions on the available contract space, the distribution function governing a project?s payoff, or the risk aversion of most potential entrepreneurs. Linear securities derive from the assumption that small business financing involves more uncertainty than is captured in most financial models. Instead of assuming that business people are faced with a given menu of projects, the model allows entrepreneurs to create (over time) an unlimited number of non-positive net present value projects with any payoff distribution they desire. Also, outside investors cannot observe project choice but only terminal cash flows. As a result, suppliers of funds must design contracts so that in equilibrium entrepreneurs do not wish to undertake undesirable investments. Further analysis of the model shows that in equilibrium entrepreneurs must contribute some of their own capital. The paper also finds that when a firm does not have any collateralizable assets, the equilibrium funding agreements have the property that the investors split the project?s proceeds in proportion to their initial investments. We further demonstrate that the existence of an infinite number of non-positive NPV projects can lead in equilibrium to positive abnormal returns earned by outside financiers. The model also produces a pecking order theory of financing. It is shown that highly profitable firms, and/or those companies run by relatively risk neutral individuals will first try to raise funds with riskless debt, and then turn to equity only when the supply of riskless debt has been exhausted. Finally, the paper shows that the linearity of the equilibrium contracts derives from the entrepreneur?s discretion with regard to the payoff distribution, rather than the flexibility associated with non-positive NPV projects. As part of the same analysis, we also demonstrate that under some conditions our underpricing results can be derived solely from the infinite supply of non-positive NPV projects.

JEL Classification: G32, D82, L14