native sources of funding for entrants, equity-holding by banks is likely to do
little damage. But where funding sources are imperfectly competitive, an in-
cumbent firm will generally disadvantage its rivals by selling equity to a bank
with a comparative advantage (e.g. specialized knowledge leading to lower cost
of funds) in funding its industry. Thus one may wonder about the wisdom of
the prescription of a universal banking system for Eastern European countries
(see Frydman et al 1993 for further discussion).
In a second application of the model, we provide an explanation for why
venture capitalists hold automatically convertible securities in start-up firms.
Until now, the reason why conversion occurs automatically has been something
of a puzzle. Existing models motivate convertibility as a means of providing
entrepreneurs with the correct incentives, so conversion is always in the venture
capitalist’s interest ex post, making the compulsion to convert redundant. We
show that convertibility can also be used to motivate venture capitalists (in
particular, not to fund competing firms); conversion is not necessarily in the
venture capitalist’s interest ex post, so compulsion is necessary.
The plan of the paper is as follows. Section 2 sets out the basic model.
Section 3 examines the second-best financial contract between the incumbent
firm and the investor, and explains why financial entry deterrence will not
generally be possible under such a contract. The entry deterring (third best)
contract is set out in section 4. Section 5 discusses some extensions of the
basic model, and section 6 presents the applications to banking regulation and
venture capital. Section 7 concludes.
2 The Model
2.1 Basic Structure
Two entrepreneurs have the opportunity to enter a new and profitable industry;
each of them has to make an investment Ii in order to enter the industry and
produce. The entrepreneurs have no internal funds: thus, they must borrow
Ii from an external investor.3
For ease of exposition, we assume that only one investor can finance this
industry. This assumption is not essential to our results, which would hold
provided there is some form of imperfect competition between investors.4 How-
3 For evidence that entrepreneurs are indeed constrained in setting up and running firms
by their ability to borrow, see Holz-Eakin et al (1994) and Evans and Jovanovic (1989).
4 The simplification from imperfect competition to monopoly is standard in the foreclosure
literature (see Rey and Tirole, forthcoming). The incentive to exclude clearly depends on
the idea that there is imperfect competition between investors, since otherwise an entrant
denied funding will simply accept an identical offer from another investor. For evidence that
some financial markets are indeed uncompetitive, we refer the reader to the later discussion