Financial Contracting and the Specialization of Assets∗

In an incomplete contracts setting, we analyze the nature of financial contracting when the entrepreneur can decide on the degree of specificity of investments. By investing in project-specific assets, an entrepreneur increases the productivity of his project but decreases its liquidation value. In debt financing, there is an additional strategic incentive to specialize assets to decrease the bargaining power of the lender. Although specializing assets is socially optimal, debt financing may not be feasible when assets can be made highly specialized. Equity financing, provided by an active investor such as a VC, may be feasible when there is greater scope for specializing the assets because the VC’s effort becomes more valuable as assets become more specific. In turn the VC’s effort helps persuade the entrepreneur to take the firm public and allows the VC to cash out. VC equity financing results in socially optimal investment and exit decisions; however, convertible contracts, which introduce inefficient liquidation, are also used to ensure the feasibility of financing. We predict that firms with greater opportunity to specialize will be mostly financed by equity versus debt and firms financed by convertible contracts are more likely to go public