Optimal financial contracts with unobservable investments

Motivated by the informational 'opacity' that often characterizes small firms, this article studies a security design problem in which outside investors are unable to observe entrepreneurs' investments decisions and their firms' net-worth, both before and after contracts are signed. The investment size affects the probability of higher profit realizations and depends both on the amount of the entrepreneur's initial capital (or type) and on the firm's access to outside funds. The interconnectedness of these three different forms of asymmetric information implies as many risks in the design problem: a possible adverse selection on entrepreneurs' types; moral hazards both on investments and on the release of information related to the firm's income/profits. Our approach and model is an extension of the classical, reduced-form one used in the moral hazard literature. The results we present establish that outside finance should take the form of a debt contract, whose terms are: a firm's capitalization requirement, a fund size, a payment schedule, a verification/auditing rule. Optimal contracts form a menu; those for higher capitalized firms are of larger size, carry a lower interest rate and lower expected costs of auditing. The payment schedule is the one of standard debt contracts; however, due to the role played by capital, the 'bankruptcy' region is narrower than prescribed in previous studies and decreasing in the firm's initial net-worth.