TL;DR
This paper models how financial contracts serve as screening devices, balancing liquidity provision and type separation, explaining the coexistence of different trade credit and venture capital practices.
Contribution
It develops a theoretical framework showing how optimal contracts balance liquidity and screening, revealing the role of advance shares and subsidies in financial arrangements.
Findings
Optimal contracts use advances to pool types and contingent transfers to separate them.
A uniform subsidy can reduce the value of relationships by cheapening finance.
The model explains coexistence of early payment and contingent compensation in finance.
Abstract
A principal with cheap capital optimally forces her counterparty to borrow at above-market rates. The reason: the form of finance is a screening device. Advances provide liquidity but pool types; contingent transfers separate types, but, because they are not pledgeable, impose financing costs. The optimal contract preserves outside-finance exposure to maintain screening power. Two sufficient statistics pin down the optimal advance share. With complementary counterparties, a uniform subsidy that cheapens finance across every relationship can reduce the value of each. This explains the coexistence of early payment and contingent compensation in trade credit, venture capital, and internal capital markets.
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