Abstract
We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. The optimal contract must induce the entrepreneur both to choose a particular investment and to repay the investor; what complicates the problem is that once the contract is signed, the entrepreneur's incentives to invest may differ from his ex-ante incentives. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. We further show that when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the entrepreneur's decision concerns his managerial effort or the riskiness of a project, however, it may be optimal to write a contract with a greater threat of liquidation, in order to induce the entrepreneur to exert more effort or to choose a less risky project.
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