An Incomplete Contracts Approach to Financial Contracting

Abstract

We analyze incomplete long-term financial contracts between an entrepreneur with no initial wealth and a wealthy investor. Both agents have potentially conflicting objectives since the entrepreneur cares about both pecuniary and non-pecuniary returns from the project while the investor is only concerned about monetary returns. We address the questions of (i) whether and how the initial contract can be structured in such a way as to bring about a perfect coincidence of objectives between both agents (ii) when the initial contract cannot achieve this coincidence of objectives how should control rights be allocated to achieve efficiency? One of the main results of our analysis concerns the optimality properties of the (contingent) control allocation induced by standard debt financing.