Optimal financial contracts with hidden effort, unobservable profits and endogenous costs of effort

Abstract

This paper studies financial contracting in a two-period financing model with double moral hazard, as entrepreneurial effort choices and profits are unobservable and non-verifiable. The optimal financial contract must induce both the high effort level and truthful revelation of profits. The paper further analyses the structure of the optimal contract where the entrepreneur's payoff takes a general functional form that allows for endogenously determined costs of effort. The entrepreneur's performance is influenced by not only extrinsic work motivation factors but also intrinsic factors so that the degree of control imposed by the investor, in the form of end-of-period transfers, affects the entrepreneur's costs of effort. The finding shows that under well-defined conditions, the optimal contract that solves a model with non-verifiable profits also elicits effort, and generally resembles a simple debt contract. The structure of the optimal contract is robust in the general case where the entrepreneur's payoff function is non-linear in transfers.