Renato Gomes, Toulouse School of Economics
Cross-Subsidization and Matching Design
Abstract: We study optimal contracting in a setting that combines experimentation and adverse selection.
In our leading example, an entrepreneur (agent) is better informed than the investor
(principal) about both the quality the project (risky arm’s distribution) and the entrepreneur’s
outside option (payoff of the safe arm). The investor’s profit-maximizing mechanism can be
uniquely implemented with a menu of equity contracts with different provisions on control rights.
In each of these contracts, the investor offers a fixed initial payment (seed money) in exchange
for a fixed share of the total revenue (equity), and a termination clause that specifies the critical
number of failures before the project is aborted. We obtain necessary and sufficient conditions
for the investor to extract all the rents from the entrepreneur’s expertise on project quality. Our
model has implications for the design of contracts to finance innovative activities.