Working Paper: CEPR ID: DP3475
Authors: Catherine Casamatta
Abstract: This paper analyses the joint provision of effort by an entrepreneur and by an advisor to improve the productivity of an investment project. Without moral hazard, it is optimal that both exert effort. With moral hazard, if the entrepreneur's effort is more efficient (less costly) than the advisor's effort, the latter is not hired if she does not provide funds. Outside financing arises endogenously. This paper thus provides a theory for why investors like venture capitalists are value enhancing. The optimal amount of outside financing is determined. Last, it is optimal to issue common stocks when the level of outside financing is not too large, while it is optimal to issue convertible bonds when the outside financing is large. These results are consistent with empirical evidence on venture capital.
Keywords: Convertible Bonds; Double Moral Hazard; Outside Finance; Venture Capital
JEL Codes: G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| efficiency of entrepreneur's effort (D29) | choice of advisor (D70) |
| outside financing (G29) | project profitability (O22) |
| level of investment (G31) | type of financial claim issued (G12) |