Financing Entrepreneurs: Optimal Contracts and the Role of Intermediaries

Publication Date
Financial Markets Group Discussion Papers DP 328
Publication Authors

I study an economy in which entrepreneurs seek financing for longterm projects from capital-constrained intermediaries, who specialise in monitoring, and uninformed investors. Monitoring enables an intermediary to affect investment decisions, and may confer an informational advantage at the interim stage. Optimal financial contracts are designed to induce both ex ante (choice of investment project) and ex post (decision to continue or liquidate at the interim stage) efficiency, while economising on the use of scarce intermediary capital.
Under certain assumptions, a degree of asymmetric information at the interim stage (between informed insiders and uninformed outside investors) makes it possible to improve on contracting possibilities for the symmetric information case. The paper identifies circumstances in which “venture capital” contracts are optimal.