Project Payoff Research Articles

Optimal Financial Contracts for a Start-Up with Unlimited Operating Discretion

The model presented here shows that extreme uncertainty between an entrepreneur and po? tential investors can lead to the exclusive use of equity and riskless debt for small business financing. The paper derives these results without any restrictions on the available contract space, the distribution function governing a project's payoff, or the risk aversion of most potential entrepreneurs. In addition, the model produces predictions regarding the under? pricing of securities to outside financiers, the order in which firms will issue securities, and the relationship between the types of securities a firm will issue and its available collateral. Most security design and optimal contracting papers assume (explicitly or implicitly) that entrepreneurs are endowed with a menu of projects. Securities are then issued in order to raise money and induce the entrepreneurs to select better projects, in a sense that varies with the assumed objective functions. In contrast, this paper focuses on an environment in which the very existence of contracts leads entrepreneurs to create projects that take advantage of the incentive structure presented to them. Furthermore, we assume that outsiders cannot observe project selection. This set-up characterizes a situation of great uncertainty on the part of outside investors, typical of start-up firms, some IPOs, and other hard-to-gauge investments.

Robust Financial Contracting and the Role of Venture Capitalists

ABSTRACTWe derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information, and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed‐fraction contract, where he always receives a fixed fraction of the project's payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds.

Optimal selection of R&D projects

A model for the selection process of research and development (R&D) projects belonging to some common area and submitted to a funding agency is presented. Every project is evaluated, the result of this procedure providing the agency with some useful information about the distribution of the project's payoff. The uncertainty due to the unknown perspectives of the whole area of R&D is incorporated in a Bayesian way, so that the agency learns about the “area value” from the projects already handled. After specifying the model assumptions, adaptive dynamic programming techniques are applied to develop an optimal funding strategy for a given number of submitted projects. Some qualitative properties of the optimal strategy are derived, and the asymptotical behavior of the maximum expected reward is determined.