Optimal Dynamic Contracts in Financial Intermediation: With an Application to Venture Capital Financing

This paper extends the costly state verification model from Townsend (1979) to a dynamic and hierarchical setting with an investor, a financial intermediary, and an entrepreneur. Such a hierarchy is natural in a setting where the intermediary has special monitoring skills. This setting yields a theory of seniority and dynamic control: it explains why investors are usually given the highest priority on projects' assets, financial intermediaries have middle priority and entrepreneurs have the lowest priority; it also explains why more cash flow and control rights are allocated to financial intermediaries if a project's performance is bad and to entrepreneurs if it is good. I show that the optimal contracts can be replicated with debt and equity. If the project requires a series of investments until it can be sold to outsiders, the entrepreneur sells preferred stock (a combination of debt and equity) each time additional financing is needed. If the project generates a series of positive payoffs, the entrepreneur sells a combination of short-term and long-term debt.