Discussion Paper Details

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Title: Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence

Author(s): Augustin Landier and David Thesmar

Publication Date: July 2003

Keyword(s): entreprenuership, financing structure and optimism

Programme Area(s): Financial Economics and Industrial Organization

Abstract: This Paper looks at the effects of entrepreneurial optimism on financial contracting and corporate performance. Optimism may increase effort, but is bad for adaptation decisions as the entrepreneur underweights negative information. The first-best contract with an optimist uses contingencies to ?bridge the gap in beliefs?. When only debt contracts are possible, we show that insurance motives lead realists to prefer long-term debt, whereas short-term debt is the optimal contract for optimists. With short-term debt, the investor: (1) gets cash-flow claims on states that the optimistic entrepreneur finds relatively unlikely, and the entrepreneur gets as much as possible from the states that they ?dream to be true?; (2) gets control in states where the optimistic entrepreneur would behave inefficiently, which decreases the ex-ante cost of capital. We confront our theory with a large dataset of entrepreneurs. We find that differences in beliefs may be (partly) explained by usual determinants put forward in psychology and management literature. We find that firms run by optimists tend to be grow less, die sooner and be less profitable, which we view as a confirmation that our measure of optimism does not proxy high risk-high return projects. Finally, in line with the prediction of our theory, we find that optimists tend to put in more effort, and use more short-term debt to finance their ventures.

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Bibliographic Reference

Landier, A and Thesmar, D. 2003. 'Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence'. London, Centre for Economic Policy Research.