Entrepreneurs must experiment to learn how good they are at a new activity. What happens when the experimentation is financed by a lender? Under common scenarios, i.e., when there is the opportunity to learn by "starting small" or when "noncompete" clauses cannot be enforced ex post, we show that financing experimentation can become harder precisely when it is more profitable, i.e., for lower
values of the known arm and for more optimistic priors. Endogenous collateral requirements (like those frequently observed in microcredit schemes) are shown to be part of the optimal contract.
Drugov, Mikhail, and Rocco Macchiavello.
American Economic Journal: Microeconomics,
Asymmetric and Private Information; Mechanism Design
Banks; Depository Institutions; Micro Finance Institutions; Mortgages
Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
Firm Performance: Size, Diversification, and Scope