In Search of a Unicorn: Dynamic Agency with Endogenous Investment Opportunities

Abstract

We study the optimal dynamic contract that provides incentives for an agent (e.g., SPAC sponsor, VC general partner, CTO) to exploit investment opportunities/targets that arrive randomly over time via a costly search process. The agent is privy to the arrival as well as to the quality of the target and can take advantage of this for rent extraction during the search process and the ensuing production. The optimal contract provides the agent with incentives for timely and truthful reporting via a time-varying threshold for investment and an internal charge for the time spent on search. In the equilibrium, as time elapses, the charge becomes progressively higher while the investment threshold is progressively lower, resulting in overinvestment at a time-varying degree. Our model generates empirically testable predictions regarding investments (such as M\&As, hedge fund activism, VC investing, SPACs, and internal innovations), linking the degree of overinvestment to observable firm and industry characteristics.

Keywords: dynamic agency, endogeneous search, project selection, overinvestment

JEL Classification: G31, D82, D83, D86, M11