Growth, Investor Protection and Security Design

Abstract

We analyze the optimal financial contract of a growing firm. The analysis is based on firms' need to repeatedly raise funds in the presence of information asymmetries. When insiders can divert funds from the firm at the expense of investors and at the expense of future investment, valuable future growth opportunities act as a disciplinary device. Namely, they provide insiders with the incentive to repay investors and mitigate the need for control mechanisms (e.g., monitoring by investors). The optimal financial contract resembles a combination of external equity and risky debt. The fraction of investment that is financed with external equity is shown to be higher for firms with more valuable growth opportunities. Outside equity emerges as an optimal security entirely as a consequence of the dynamics of the problem. In a one-period version of the model, the optimal security is debt. The model can help explain the reliance of high-growth firms on equity financing, the well-known empirical regularity that more profitable firms have lower leverage ratios, and is consistent with firms' reliance on equity financing in countries with strong investor protection.

Keywords: Financial Contracts, Investor Protection, Security Design, Outside Equity, Debt financing, Firm Dynamics

JEL Classification: G33, G32, G24