Limited Liability and Option Contracts in Models with Sequential Investments

The paper investigates a model where two parties A and B invest sequentially in a joint project (an asset). Investments and the asset value are nonverifiable, and A is wealth constrained so that an initial outlay must be financed by either agent B or an external investor C (a bank). We show that an option contract in combination with a loan arrangement facilitates first best investments and any arbitrary distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, the first best can still be attained if A's bargaining position is not too strong. In addition, either B-financing or C-financing may be strictly preferable, and a combination of multiple lenders may be optimal