#08-14
Financial Contracting and the Specialization of Assets
Robert Marquez and M. Deniz Yavuz, April 2008
Abstract:We analyze the nature of financial contracting when an entrepreneur can choose the
specificity of investments and financial contracts are incomplete. Investing in project-specific
assets increases productivity but decreases liquidation value. This creates a
strategic incentive to specialize assets to decrease the bargaining power of the lender,
which may make debt financing infeasible. By contrast, equity financing provided by
a financier who contributes to the project, such as a VC, may be feasible because his
contribution becomes more valuable as assets become more specialized. This helps
persuade the entrepreneur to take the firm public, making cash flows contractible and
allowing the financier to cash out. The entrepreneur faces a tension between going
public, which is costly but induces the financier to exert effort, and remaining private,
which limits the opportunities for contracting but allows the entrepreneur to divert
cash flows. We predict that firms with greater opportunity to specialize will be mostly
financed by equity, which results in optimal investment and exit decisions. Convertible
contracts may also be used to ensure the feasibility of financing, but they increase the
firm’s likelihood of inefficiently going public.
Keywords: banks, venture capital, incomplete contracts, asset specificity, financial contracts.
JEL classifications: G21, G24, G32.
