Optimal Security Design Under Asymmetric Information and Profit Manipulation

We consider a model of external financing in which entrepreneurs are privately informed about the quality of their projects and seek funds from competitive financiers. The literature restricts attention to monotonic or ‘manipulation proof' securities and finds that straight debt is the unique optimal contract. We characterize the optimal contract when entrepreneurs can misreport their earnings by some amount. Straight debt is often suboptimal and never uniquely optimal. The optimal contract is non-monotonic and involves profit manipulation in equilibrium. It can be implemented either including performance-based bonuses, or via milestone payments, (as in venture capital)