Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence

Optimistic beliefs are a source of nonpecuniary benefits for entrepreneurs that can explain the “Private Equity Puzzle. ” This paper looks at the effects of entrepreneurial optimism on financial contracting. When the contract space is restricted to debt, we show the existence of a separating equilibrium in which optimists self-select into short-term debt and realists into long-term debt. Long-term debt is optimal for a realist entrepreneur as it smooths payoffs across states of nature. Short-term debt is optimal for optimists for two reasons: (i) “bridging the gap in beliefs ” by letting the entrepreneur take a bet on his project’s success, and (ii) letting the investor impose adaptation decisions in bad states. We test our theory on a large data set of French entrepreneurs. First, in agreement with the psychology literature, we find that biases in beliefs may be (partly) explained by individual characteristics and tend to persist over time. Second, as predicted by our model, we find that short-term debt is robustly correlated with “optimistic ” expectation errors, even controlling for firm risk and other potential determinants of short-term leverage. (JEL G32, D86) Starting a business is not a profitable activity: Hamilton (2000) documents that median entrepreneurial earnings after ten years of business are 35 % less than the predicted alternative wage on a paid job of the same duration. In addition, because the bulk of their wealth is invested in their own business, entrepreneurs bear a substantial amount of risk that can be explained only by large private benefits: Moskowitz and Vissing-Jorgensen (2002) estimate that entrepreneurs must enjoy nonpecuniary benefits as high as 5–20 % of their investment every year. These “private benefits of control, ” as the literature calls them, may correspond to pure hedonic flows: social status, the fun of running a firm, or the independence that comes with it. In this case, however, one would be lef