Financial Economics

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FINANCIAL CONTRACTING AND DEAL TERMS

In Chapter 7, we described deal terms. Corporate management in need of external funds must design and negotiate terms with financiers. The formalization of the terms of the agreement between the supplier and demander of funds is memorialized in a contract. The process is referred to as financial contracting.¹ The literature on financial contracting seeks to explain what kinds of deals are made between financiers and corporate management and helps us understand why different forms of contractual relations are observed in practice between firms and financiers (i.e., investor groups). Basically, financial contracting seeks the optimal security design for overcoming conflicts between financiers and those entities seeking funding. Much of the focus in the application of financial contracting has not been on large public firms but, instead, primarily on small entrepreneurial firms.

We first explain how the informational conditions under which a deal (i.e., a financing) is originated—and the likely evolution of that information—have important implications for selecting deal terms. When deals are arranged under risk, they can be formulated as complete contracts. In addition, when they are arranged under conditions of symmetric information, it is relatively easy to select appropriate terms. However, if the deals are arranged under conditions of information asymmetry, they usually present potential complications of moral hazard and adverse selection. ...