, Volume 17, Issue 4, pp 586-614
Date: 07 Jan 2014

Incentive effects of funding contracts: an experiment

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Abstract

We examine the incentive effects of funding contracts on entrepreneurial effort and on allocative efficiency. We experiment with funding contracts that differ in the structure of investor repayment and, thus, in their incentives for the provision of entrepreneurial effort. Theoretically the replacement of a standard debt contract by a repayment-equivalent non-monotonic contract reduces effort distortions and increases efficiency. Likewise, distortions can be mitigated by replacing outside equity by a repayment-equivalent standard-debt contract. We test both hypotheses in the laboratory. Our results reveal that the incentive effects of funding contracts must be experienced before they are reflected in observed behavior. With sufficient experience, observed behavior is either consistent with or close to theoretical predictions and supports both hypotheses. If we allow for entrepreneur-sided manipulations of project outcomes, we find that non-monotonic contracts lose much of their appeal.

Financial support from Maastricht University through METEOR is gratefully acknowledged. We thank Paul Smeets and audiences in Alicante (IMEBE2008), Caltech (ESA2008), Gothenburg (ESEM2013), Heidelberg, Luxembourg (GfEW2010), and Lyon (ESA2008) for helpful comments. The paper greatly benefited from helpful suggestions and comments of Jordi Brandts and two anonymous reviewers.