Moral Hazard and Capital Structure Dynamics, Second Version

We base a contracting theory for a start-up firm on an agency model with observable but nonverifiable effort, and renegotiable contracts. Two essential restrictions on simple contracts are imposed: The entrepreneur must be given limited liability, and the investor's earnings must not decrease in the realized profit of the firm. All message game contracts with pure strategy equilibria (and no third parties) are considered. Within this class of contracts/equilibria, and regardless of who has the renegotiating bargaining power, debt and convertible debt maximize the entrepreneur's incentives to exert effort. These contracts are optimal if the entrepreneur has the bargaining power in renegotiation. If the investor has the bargaining power, the same is true unless debt induces excessive effort. In the latter case, a non-debt simple contract achieves efficiency; the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: An early use of debt claims, followed by a switch to equity-like claims