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

Rb^L2 ≥ 0, Rb^H2 ≥ 0

V₂ is the net present value of Firm 2’s project, net of agency costs, when
Firm 2 is “bad”. Let us assume:

V 2 < 0

A bad-type Firm 2 is never worth funding. This means that the Coase
problem will not arise if, in the process of funding Firm 1, the venture capitalist
receives a bad signal about Firm 2.

Funding a good-type Firm 2 yields V₂ to the venture capitalist, where V₂ is
as defined in section 3.2. We assume that condition (1) holds, i.e. the venture
capitalist is tempted to fund firm 1’s rival whenever he receives good signals
about its profitability (and holds the ”second best claim” in Firm 1).

Contracts

The financial contract with Firm 1 can be made contingent on the signal
observed at stage 2. Thernefore, a contract sopecifies the firm’s payoffs in each
possible state of nature: RL, RH, R_b, R_b . RL (RH) is the entrepreneur’s
reward in case of failure (success), contingent on a bad signal being observed at
stage 2, and RL ( RH) is the entrepreneur’s reward in case of failure (success)
contingent on a good signal being observed at stage 2.

The optimal contract to be offered to Firm 1 will solve the following pro-
gram:

h       -H                -L i

MaxRH RL RH RL e_e ^α_he⁽R^{H -} Rb ) ^{+ (1 -} e)⁽R^{L -} Rb ). ⁺
Rb ,Rb ,Rb ,Rb ,e,^e    h                                                  i

(1 — α) e(RH — RH) + (1 — e)(RL — RL) — Ii

(IR )            e RH + (1 — e) RL — Ψ(e) ≥ W

(IR)            eR_bH + (1 — e)RL — Ψ(e) ≥ W

(IC)             RH — RL = Ψ0(e), RH — RL = 'I' e

(ICi)             e(RH — RH) + (1 — e)(RL — RL) ≥

(e — ∆)(RH — Rb ) + (1 — e + ∆)(RL — Rb ) + V2

(LL)             RL ≥ 0, RH ≥ 0, RL ≥ 0, RH ≥ 0

We will refer to this as the venture capitalist’s program. According to
whether a good or a bad signal is observed at stage 2, effort e or e is im-
plemented. As the entrepreneur may abandon the project after the signal is
observed, the contract must satisfy his ex-post participation constraints IR
and IR: not only must the entrepreneur be willing to accept the contract at
date 1, but he also must continue the project after receiving a bad or a good
signal about his potential rival. (IC),thefirm’s incentive constraint, gives the

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