Motivating entrepreneurial activity in a firm ∗

We consider the problem of motivating privately informed managers to engage in entrepreneurial activity to improve the quality of the firm’s investment opportunities. The firm’s investment and compensation policy must balance the manager’s incentives to provide entrepreneurial effort and to report her private information truthfully. The optimal policy is to underinvest (compared to first-best) and provide weak incentive pay in low-quality projects and overinvest (compared to first-best) and provide strong incentive pay in high-quality projects. We also show that, unlike the standard agency model, uncertainty and incentives can be positively related. ∗We thank seminar participants at the University of Illinois at Urbana-Champaign, Stanford, and UC, San Diego for helpful comments. All errors are ours. †UCLA Anderson School, 110 Westwood Plaza Box 951481, Los Angeles, CA 90095-1481, USA. e-mail: [email protected] ‡Department of Economics, UCLA, Los Angeles, CA 90095-1477, USA. e-mail: [email protected] §Department of Finance, HKUST, Clear Water Bay, Hong Kong. e-mail: [email protected]