Optimal Financial Contracts for a Start-Up with Unlimited Operating Discretion

Abstract

The model presented here shows that extreme uncertainty between an entrepreneur and potential investors can lead to the exclusive use of equity and riskless debt for small business financing. The paper derives these results without any restrictions on the available contract space, the distribution function governing a project's payoff, or the risk aversion of most potential entrepreneurs. In addition, the model produces predictions regarding the “under-pricing”; of securities to outside financiers, the order in which firms will issue securities, and the relationship between the types of securities a firm will issue and its available collateral.