Informed Investors and the Financing of Entrepreneurial Projects

Abstract

We consider a model of the financing of a small-business venture in which it is presumed that outside investors have greater expertise in project evaluation than the entrepreneur. We show that entrepreneurs and investors may restrict themselves to debt and junior equity (call option) contracts without loss of efficiency. A "pecking order" for new ventures is demonstrated, in which entrepreneurs prefer to be financed by junior equity rather than by debt. In addition, the model correctly predicts that large and successful venture-capital firms are likelier to hold debt stakes and makes untested predictions about the lending patterns of specialist banks.