Monitoring, liquidation, and security design

By identifying the possibility of imposing a credi-ble threat of liquidation as the key role of informed (bank) finance in a moral hazard con-text, we characterize the circumstances under which a mixture of informed and uninformed (market) finance is optimal, and explain why bank debt is typically secured, senior, and tightly held. We also show that the effectiveness of mixed finance may be impaired by the possi-bility of collusion between the firms and their informed lenders, and that in the optimal rene-gotiation-proof contract informed debt capacity will be exhausted before appealing to supple-mentary uninformed finance. This article develops a model of how entrepreneurial firms source their financing needs. There are three al-ternatives for raising finance: uninformed, informed, and a mixture of both. Under informed finance the lender observes at a certain cost the entrepreneur’s level of effort, which determines the probability of success of his project. Although this information can-not be used to enforce a contingent contract, it en-ables the lender to liquidate the project (and recover part of the investment) if the observed effort does not guarantee her a sufficient continuation payoff. When liquidation values are large enough, a credible threat of liquidation leads the entrepreneur to choose first