Ehsan Azarmsa, Lin William Cong - August 18, 2017
Relationship financing of innovative projects, as is common in bank lending and venture capital, features incumbent financiers' observing interim information before deciding on continued financing. Entrepreneurs' endogenous experimentation reduces the insider investor's information monopoly rent, but the moral hazard of information production in such persuasion games reduces the incentives for initial investment. Insiders' independent information and competition mitigate the hold-up problem and, consistent with empirical observations, have non-monotone effects on relationship formation. Because experimentation only alters the informational environment and not the underlying project cash flows, optimal contracts independent of investor sophistication and entrepreneur's private benefit achieves the first best: the entrepreneur issues warrants in the initial round for purchasing convertible securities later, then raises the remaining investment by selling residual claims to competitive outsiders. We further characterize conditions for equity, debt, and call option to be optimal, and demonstrate robustness of our findings, for example under scalable investment and partial commitment to information design.