ANTI-COMPETITIVE FINANCIAL CONTRACTING: THE DESIGN OF FINANCIAL CLAIMS.

Provided by Research Papers in Economics

Anti-Competitive Financial Contracting: The
Design of Financial Claims*

Giacinta Cestone^and Lucy White+

WP UAB-IAE 453.00

April 6, 2000

Abstract

This paper presents the first model where entry deterrence takes
place through financial rather than product-market channels. In stan-
dard models of the interaction between product and financial markets, a
firm’s use of financial instruments deters entry by affecting product mar-
ket behavior, whereas in our model entry deterrence occurs by affecting
the credit market behavior of investors towards entrant firms. We find
that in order to deter entry, the claims held on incumbent firms should
be sufficiently risky, i.e. equity, in contrast to the standard Brander-
Lewis (1986) result that debt deters entry. The model sheds light on the
policy debate on the separation of banking as to whether banks should
be permitted to hold equity in firms. It also provides an explanation
for why venture capitalists hold automatically convertible securities in
start-up firms.

Keywords: Coase Problem, Over-funding, Venture Capital, Convert-
ible Debt

JEL Classification: G3

*We would like to thank Jean Tirole for his comments and encouragement. We are also
grateful to Denis Gromb, Josh Lerner, David Martimort, Marco Pagano, Michele Polo, Lam-
bros Pechlivanos, Patrick Rey and Oved Yosha for very helpful insights. We thank seminar
participants at Universitat Autonoma de Barcelona, University College of London, Univer-
sité de Toulouse, CSEF-University of Salerno, Ente Einaudi and the EEA99 meeting. The
first author acknowledges financial support from Ente Luigi Einaudi, Rome and the TMR
Network on “The Industrial Organization of Banking and Financial Markets in Europe”.
Address for correspondence: Giacinta Cestone, Institut d’Anàlisi Economica, Campus UAB,
08193 Bellaterra Barcelona, Spain. E-mail: [email protected]

^ GREMAQ, Université de Toulouse and Institut d’Anàlisi Economica CSIC, Barcelona.

^GREMAQ, Université de Toulouse and Nuffield College, Oxford.

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