Creditor Heterogeneity and Absolute Priority Rule Violation in Entrepreneurial Finance

We present a model of cash constrained entrepreneurs who raise money from banks and from dispersed uninformed creditors. There is a moral hazard problem, which can be partially overcome through bank monitoring. However, monitoring is only effective if the bank can commit ex ante to liquidate after a poor signal. We show that this is possible only if the continuation value of a poorly performing firm is reduced for the bank by anticipated violation of the Absolute Priority Rule (APR) in favour of junior creditors. Two classes of creditors with APR violation therefore constitutes an optimal capital structure.