Financing and Advising: Optimal Financial Contracts withVenture Capitalists

This paper analyses the joint provision of e¡ort by an entrepreneur and by an
advisor to improve the productivity of an investment project.Without moral
hazard, it is optimal that both exert e¡ort.With moral hazard, if the entrepreneur’s
e¡ort is more e⁄cient (less costly) than the advisor’s e¡ort, the latter is
not hired if she does not provide funds. Outside ¢nancing arises endogenously.
This explains why investors like venture capitalists are value enhancing.The
level of outside ¢nancing determines whether common stocks or convertible
bonds should be issued in response to incentives.