Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence

Abstract

This paper looks at the effects of entrepreneurial optimism on financial contracting and corporate performance. Optimism may increase effort, but is bad for adaptation decisions as the entrepreneur underweights negative information. The first-best contract with an optimist uses contigencies for two distinct purposes: (1) bridging the gap in beliefs by letting the entrepreneur take a bet on his project's success, and (2) imposing adaptation decisions in bad states. When the contract space is restricted to debt, there may exist a separating equilibrium where optimists self-select in short-term debt and realists in long-term debt.

We confront our theory to a large dataset of entrepreneurs. First, we find that differences in beliefs may be (partly) explained by usual determinants put forward in psychology and management literature. Second, in line with the two main predictions of our model, we find that (1) optimists tend to borrow more short term and (2) those optimists that borrow more short term perform better. Last, we find that firms run by optimists tend to grow less, die sooner and be less profitable, which we view as a confirmation that our measure of optimism does not proxy high risk - high return projects.