Informed Finance?∗

This paper investigates basic issues in contracting and information acquisition for entrepreneurial finance. Specifically, we determine how the nature and quality of the information acquired by a financier, the equilibrium contracting terms, and the allocation of control rights are affected by the possibility of outside funding. We pose these questions in an environment where it is costly for a financier to screen investment projects, and uninformed investors can compete to provide funding. If the financier does investigate, he must choose how carefully to investigate the project’s quality, and the actions that maximize the project’s payoff. Four distinct types of equilibria may exist, which we categorize by their real world counterparts: venture capital finance, angel finance, bank finance and no finance equilibria. We derive the project characteristics that support each equilibrium type, and fully characterize each equilibrium form, including signal choices, contract structure and welfare properties. ∗We are grateful to Peter Norman, Mattias Polborn, Per Stromberg and Ján Zábojnik for helpful comments. We appreciate the audiences at the University of Chicago GSB, Carnegie-Mellon University, University of Toronto, University of Illinois, University of British Columbia, and the Western Finance Association Meetings in Tucson. Dan Bernhardt gratefully acknowledges financial support from NSF grant SES-0317700. Stefan Krasa gratefully acknowledges financial support from NSF grant SES-0318394. We are responsible for all errors.