Optimal Financial Contracting in Strategic Alliances

Abstract

This paper models a financially constrained entrepreneur and a deep-pocket incumbent developing an innovative product through strategic alliance, which generates externalities on the incumbent. We find that i) the main agency conflict in alliances is the free-riding problem between the two collaborators, and a third party - an outside investor - is introduced to address this problem; ii) in contrast to traditional corporate finance theories, the financial constraint of the entrepreneur sometimes can be tightened by an increase in his endowment or a reduction in agency conflicts; and iii) the incentive compatible financial claims of alliances include debt, equity, warrants, convertible debt, and preferred equity, which are consistent with empirical observations.