Screening and Financial Contracting in the Face of Outside Competition

This paper considers an investor who, at a cost, can acquire a signal about whether an entrepreneurial project will generate positive surplus. The problem for the potentially informed investor is that uninformed investors can compete to provide funding and the informed investor’s contract offer conveys a signal to the entrepreneur about the project’s likely payoffs, affecting the attractiveness to the entrepreneur of his uninformed funding alternatives. We determine how the investor’s choices of signal quality and contracting terms are affected by project primitives. We prove that equilibrium expected payoffs in this signaling game are unique. We solve the optimal contracting problem for both the informed and uninformed investors, showing that informed investors can use equity, and that, under mild conditions, uninformed investors will compete with simple debt. Finally, we show that introducing the possibility of commitment by the informed investor alters the structure of the game, but not equilibrium payoffs.