40 Pages Posted: 20 Jul 2004
Date Written: July 2004
We analyze how optimal contracting between an entrepreneur and a financial institution depends on the cash flow characteristics of the entrepreneur's firm. Because the entrepreneur prefers continuing the firm over liquidating it, and aggressive continuation strategies over conservative strategies, the institution must monitor the firm and exercise some control over its decisions. The institution's own liquidity concerns make it prefer less exposure to the firm's risk, all else equal. For firms with limited financial slack, the optimal contract resembles convertible debt only if the institution monitors more actively; otherwise, the optimal contract is debt. Convertible debt and active monitoring (venture capital finance) are optimal only when the following conditions are met: (1) the aggressive continuation strategy is not too profitable on average, ex-ante; (2) the firm faces high uncertainty in its choice of continuation strategy; and (3) the firm's cash flow distribution is highly skewed, with low probability of success, low liquidation value, and high returns if successful. If these conditions are not met, debt and passive monitoring (bank finance) are optimal. These results mirror entrepreneurial firms' actual choice between bank finance and venture capital finance.
For firms with somewhat higher financial slack and high strategic uncertainty, a third option may be optimal: convertible debt with passive monitoring by the institution. This resembles the circumstances and structure of so called mezzanine finance.
Keywords: Venture capital, entrepreneurial finance, monitoring, convertible debt
JEL Classification: G24, G20, G33
Suggested Citation: Suggested Citation