The Simple Analytics of Informed Finance∗

The paper derives two analytical consequences of informed finance: Equity leads to under-financing, while debt leads to over-financing. We show that our model can explain key qualitative and quantitative features of informed venture capital finance in the United States. Using only three model parameters we match: (1) the venture capitalist’s equity share; (2) the venture capitalist’s expected return and (3) its standard deviation; (4) the probability that a project receives funding; and (5) the probability the venture capitalist loses money on an investment. We then use the model to make predictions about features that cannot be readily identified from the data, such as the magnitude of under-financing with equity, and the surplus from using equity instead of debt. ∗Dan Bernhardt gratefully acknowledges financial support from NSF grant SES-0317700 . Stefan Krasa gratefully acknowledges financial support from NSF grant SES-0318394. We are grateful to Per Stromberg for helping us uncover the relevant empirical regularities. We thank John Cochrane for giving us access to his data and appreciate the guidance that he provided us. We also thank Burton Hollifield, George Pennacchi, Jano Zabojnik and seminar participants at the University of Illinois. We are responsible for all errors.