Screening and Financial Contracting in the Face of Outside Competition

Abstract

This paper considers an investor who, at a cost, can acquire a signal about an entrepreneurial project's payoff. The problem for this investor is that uninformed investors can compete to provide funding and the informed investor's contract offer conveys information to the entrepreneur about the project's likely payoffs, affecting the attractiveness of the entrepreneur's uninformed funding alternatives. I determine how the investor's choices of signal quality and contracting terms are affected by project primitives. I prove that equilibrium expected payoffs in this signaling game are unique and that equilibrium strategies solve simple optimal contracting problems, showing that informed investors can use equity, and that uninformed investors compete with simple debt. Finally, I show that introducing the possibility of commitment by the informed investor alters the structure of the game, but not equilibrium payoffs.