Experimentation and project selection: Screening and learning

We study optimal contracting in a setting that combines experimentation and adverse selection. In our leading example, an entrepreneur (agent) is better informed than the investor (principal) about both the quality the project (risky arm’s distribution) and the entrepreneur’s outside option (payoff of the safe arm). The investor’s profit-maximizing mechanism can be uniquely implemented with a menu of equity contracts with different provisions on control rights. In each of these contracts, the investor offers a fixed initial payment (seed money) in exchange for a fixed share of the total revenue (equity), and a termination clause that specifies the critical number of failures before the project is aborted. We obtain necessary and sufficient conditions for the investor to extract all the rent from the entrepreneur’s expertise on project quality. Our model has implications for the design of contracts to finance innovative activities. JEL Classification: D21, J33, M12, O31, O34