Financing Entrepreneurial Production: Security Design with Flexible Information Acquisition

Abstract

We propose a theory of security design in financing entrepreneurial production, positing that the investor can acquire costly information on the entrepreneur’s project before making the financing decision. When the entrepreneur has enough bargaining power in security design, the optimal security helps incentivize both efficient information acquisition and efficient financing. Debt is optimal when information is not very valuable for production, whereas the combination of debt and equity is optimal when information is valuable. If, instead, the investor has sufficiently strong bargaining power in security design or can acquire information only after financing, equity is optimal.Received October 12, 2015; editorial decision February 10, 2018 by Editor Itay Goldstein.