Fighting for the Best, Losing With the Rest: A Case for Restricting Credit to Business Start-Ups

Sep 2017
The Jumpstart Our Business Startups (JOBS) Act of 2012 aims at increasing funding access for young firms by easing securities regulation. Motivated by this, we ask if there is a role for the regulation of the market of funds for firms that lack collateral and have a large uncertainty about their ability to generate profits. To answer that we characterize optimal financial contracts in a competitive environment with risk, adverse selection and limited liability. We find that competition among financial intermediaries always forces them to fund projects with negative expected returns both from a private and from a social perspective. Intermediaries use steep payoff schedules to screen entrepreneurs, but limited liability implies this can only be done by giving more to all entrepreneurs.