Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

Insider Investor and Information

September 2017
Ehsan Azarmsa, Lin William Cong

We model dynamic financing of innovative projects where relational financiers observe entrepreneurs' experimentation and thus information they endogenously produce, before deciding on continued financing. We show that enterpreneurs' optimal information productions follow threshold strategies. Insider financiers extract little or no intermin rent even with full information monopoly, hindering efficient financing ex ante. Independent experimentation by insiders mitigate the problem, but can be either a complement or substitute to entrepreneurs' information production. Moderate competition also facilitates information production and relationship financing. We characterize how investors' relative sophistication and competition interact to produce the non-monotone empirical patterns linking relationship lending and competition. Our model also allows general forms of security, timing of experimentation and offer negotiation, and applies to venture financing. Financially, entrepreneurs' optimal security design is more efficient, and entails issuing convertible securities to sophisticated eary insiders, and residual claims to outsiders.