Simple contracts with double-sided moral hazard and adverse selection

Abstract

We examine a linear contract model involving a risk-neutral venture capitalist (VC) hiring a risk-averse manager to run a project. The project output is determined by the joint efforts of both parties, the manager’s private ability and a random shock. We explicitly derive a truth-telling menu of contracts, which explain that the incentives provided by VC increase with the manager’s ability, under the widely-recognized monotone hazard rate condition. The fixed compensation would be negative; thus, the manager provides a portion of the financial investment and shares risks with VC. VC’s contracts can not distinguish the types of managers in a range of low-ability managers, leading to a partially pooling equilibrium. Conversely, within a range of high-ability managers, VC’s contracts identify the types of managers, resulting in convex information rents that increase with abilities. We explicitly provide ability thresholds specifying partially or completely pooling and separating equilibrium.