The Effects of Collateralizable Income and Debt Overhang on Entrepreneurial Investment in an Open Regional Economy

We use a two period model to analyze the contractual relationship between entrepreneurs and venture capitalists in an open regional economy. First, we describe the first best investment contract, we study the second best investment contract in the presence of private information, and then we examine the impact of an exogenous second period income endowment (collateralizable income) on investment by entrepreneurs. Next, we analyze the interaction between entrepreneurs and venture capitalists when the regional government (RG) must pay off a per capita debt (debt overhang) which it finances by taxing successful second period entrepreneurs. We show that a rise in the per capita debt has an effect on investment that is analogous to a fall in the second period income endowment. In addition, the overhang of the RG's debt discourages entrepreneurial investment