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Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence

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  • Landier, Augustin
  • Thesmar, David

Abstract

This Paper looks at the effects of entrepreneurial optimism on financial contracting and corporate performance. Optimism may increase effort, but is bad for adaptation decisions as the entrepreneur underweights negative information. The first-best contract with an optimist uses contingencies to ‘bridge the gap in beliefs’. When only debt contracts are possible, we show that insurance motives lead realists to prefer long-term debt, whereas short-term debt is the optimal contract for optimists. With short-term debt, the investor: (1) gets cash-flow claims on states that the optimistic entrepreneur finds relatively unlikely, and the entrepreneur gets as much as possible from the states that they ‘dream to be true’; (2) gets control in states where the optimistic entrepreneur would behave inefficiently, which decreases the ex-ante cost of capital. We confront our theory with a large dataset of entrepreneurs. We find that differences in beliefs may be (partly) explained by usual determinants put forward in psychology and management literature. We find that firms run by optimists tend to be grow less, die sooner and be less profitable, which we view as a confirmation that our measure of optimism does not proxy high risk-high return projects. Finally, in line with the prediction of our theory, we find that optimists tend to put in more effort, and use more short-term debt to finance their ventures.

Suggested Citation

  • Landier, Augustin & Thesmar, David, 2003. "Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence," CEPR Discussion Papers 3971, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:3971
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    Citations

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    Cited by:

    1. Malmendier, Ulrike & Tate, Geoffrey, 2008. "Who makes acquisitions? CEO overconfidence and the market's reaction," Journal of Financial Economics, Elsevier, vol. 89(1), pages 20-43, July.
    2. Puri, Manju & Robinson, David T., 2007. "Optimism and economic choice," Journal of Financial Economics, Elsevier, vol. 86(1), pages 71-99, October.
    3. Karel Janda, 2006. "Lender and Borrower as Principal and Agent," Working Papers IES 2006/24, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Jul 2006.
    4. Cumming, Douglas J., 2005. "Capital structure in venture finance," Journal of Corporate Finance, Elsevier, vol. 11(3), pages 550-585, June.
    5. HansK. Hvide, 2009. "The Quality of Entrepreneurs," Economic Journal, Royal Economic Society, vol. 119(539), pages 1010-1035, July.
    6. Hyytinen, Ari & Pajarinen, Mika, 2005. "Why Are All New Entrepreneurs Better Than Average? Evidence from Subjective Failure Rate Expectations," Discussion Papers 987, The Research Institute of the Finnish Economy.
    7. Alvaro Sandroni & Francesco Squintani, 2007. "Overconfidence, Insurance, and Paternalism," American Economic Review, American Economic Association, vol. 97(5), pages 1994-2004, December.
    8. Winton, Andrew & Yerramilli, Vijay, 2008. "Entrepreneurial finance: Banks versus venture capital," Journal of Financial Economics, Elsevier, vol. 88(1), pages 51-79, April.
    9. John Armour & Douglas Cumming, 2008. "Bankruptcy Law and Entrepreneurship," American Law and Economics Review, Oxford University Press, vol. 10(2), pages 303-350.
    10. Inderst, Roman, 2006. "Consumer Lending When Lenders are More Sophisticated Than Households," CEPR Discussion Papers 5410, C.E.P.R. Discussion Papers.
    11. Robert A. Lowe & Arvids A. Ziedonis, 2006. "Overoptimism and the Performance of Entrepreneurial Firms," Management Science, INFORMS, vol. 52(2), pages 173-186, February.
    12. Josh Lerner & Ulrike Malmendier, 2013. "With a Little Help from My (Random) Friends: Success and Failure in Post-Business School Entrepreneurship," Review of Financial Studies, Society for Financial Studies, vol. 26(10), pages 2411-2452.
    13. Malcolm Baker & Richard S. Ruback & Jeffrey Wurgler, 2004. "Behavioral Corporate Finance: A Survey," NBER Working Papers 10863, National Bureau of Economic Research, Inc.
    14. Hvide, Hans K & Møen, Jarle, 2007. "Liquidity Constraints and Entrepreneurial Performance," CEPR Discussion Papers 6495, C.E.P.R. Discussion Papers.
    15. de Mel, Suresh & McKenzie, David & Woodruff, Christopher, 2008. "Who Are the Microenterprise Owners? Evidence from Sri Lanka on Tokman v. de Soto," IZA Discussion Papers 3511, Institute for the Study of Labor (IZA).
    16. Luís Santos-Pinto, 2010. "Positive Self-Image In Tournaments," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 51(2), pages 475-496, May.
    17. Bruno Biais & Denis Hilton & Karine Mazurier & Sébastien Pouget, 2005. "Judgemental Overconfidence, Self-Monitoring, and Trading Performance in an Experimental Financial Market," Review of Economic Studies, Oxford University Press, vol. 72(2), pages 287-312.
    18. Van den Steen, Eric, 2005. "Too Motivated?," Working papers 18180, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    19. Gilpatric, Scott M., 2008. "Present-biased preferences, self-awareness and shirking," Journal of Economic Behavior & Organization, Elsevier, vol. 67(3-4), pages 735-754, September.
    20. Hvide, Hans K., 2004. "Firm Size and the Quality of Entrepreneurs," Discussion Papers 2004/9, Norwegian School of Economics, Department of Business and Management Science.

    More about this item

    Keywords

    entreprenuership; financing structure; optimism;

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • M13 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - New Firms; Startups

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