DOES PENALTY ALWAYS HURT? THE SIGNALING EFFECT OF CONTINGENT CONTRACTS

This paper investigates the incentive for an entrepreneur to provide an investor with a contingent contract which specifies a penalty if the invested project failed. Based on the project’s potential, the entrepreneur can be classified into two possible types: a high-type

entrepreneur owns a good project and a low-type one owns a bad project. A good project has a higher probability of succeeding than a bad one and can yield a positive return. We build a theoretical model to analyze the entrepreneur’s equilibrium contract decision, that is, whether to offer a contingent contract with a penalty or not. Our results show that a high penalty in the contingent contract acts as a signal of a good project. Moreover,we find that the penalty commitment, which increases the entrepreneur’s capital risk, not only serves as a signal but also boosts the high-type entrepreneur’s expected profit. This is because that a higher penalty can result in a larger share of return for the entrepreneur when the project succeeds. Finally, by optimizing the penalty, we demonstrate that the entrepreneur’s type can always be distinguished by the investor according to the amount of penalty.

[1] KOHERS N, KOHERS T. The value creation potential of high-tech mergers[J]. Financial Analysts Journal, 2000, 56(3): 40-51.
[2] LEVIN J. Relational incentive contracts[J]. American Economic Review, 2003, 93(3): 835-857.
[3] LAUX V, STOCKEN P C. Managerial reporting, overoptimism, and litigation risk[J]. Journal of Accounting and Economics, 2012, 53(3): 577-591.
[4] ADMATI A R, PFLEIDERER P. Robust financial contracting and the role of venture capitalists [J]. The Journal of Finance, 1994, 49(2): 371-402.
[5] BERGEMANN D, HEGE U. Venture capital financing, moral hazard, and learning[J]. Journal of Banking & Finance, 1998, 22(6-8): 703-735.
[6] BERGEMANN D, HEGE U. The financing of innovation: Learning and stopping[J]. RAND Journal of Economics, 2005: 719-752.
[7] DE BETTIGNIES J E. Financing the entrepreneurial venture[J]. Management Science, 2008, 54(1): 151-166.
[8] HAO C, YANG L. Resale or agency sale? Equilibrium analysis on the role of live streaming selling[J]. European Journal of Operational Research, 2023, 307(3): 1117-1134.
[9] HSIAO L, CHEN Y J, XIONG H. Commission, product quality and return policy in agency selling[J]. Naval Research Logistics (NRL), 2023, 70(3): 231-245.
[10] LI Y, LI G, PAN X A. Optimal return shipping insurance policy with consumers’ anticipated regret[J]. Production and Operations Management, 2023, 32(10): 3209-3226.
[11] BARON D P, BESANKO D. Regulation, asymmetric information, and auditing[J]. The RAND Journal of Economics, 1984: 447-470.
[12] NALEBUFF B, SCHARFSTEIN D. Testing in models of asymmetric information[J]. The Review of Economic Studies, 1987, 54(2): 265-277.
[13] LAMBERT R A, LEUZ C, VERRECCHIA R E. Information asymmetry, information precision, and the cost of capital[J]. Review of finance, 2012, 16(1): 1-29.
[14] BESSLER W, DROBETZ W, GRÜNINGER M C. Information asymmetry and financing de cisions[J]. International Review of Finance, 2011, 11(1): 123-154.
[15] NAN L, WEN X. Penalties, manipulation, and investment efficiency[J]. Management Science, 2019, 65(10): 4878-4900.
[16] KALRA A, LI S. Signaling quality through specialization[J]. Marketing Science, 2008, 27(2): 168-184.
[17] FELTOVICH N, HARBAUGH R, TO T. Too cool for school? Signalling and countersignalling [J]. RAND Journal of Economics, 2002: 630-649.
[18] NAN L, WEN X. Financing and investment efficiency, information quality, and accounting biases[J]. Management Science, 2014, 60(9): 2308-2323.
[19] ZHANG C, YU M, CHEN J. Signaling quality with return insurance: Theory and empirical evidence[J]. Management Science, 2022, 68(8): 5847-5867.
[20] FAN X, CHEN Y J, TANG C S. To bribe or not in a procurement auction under disparate corruption pressure[J]. Production and Operations Management, 2021, 30(5): 1220-1245.
[21] GUO P, HAVIV M, LUO Z, et al. Signaling service quality through queue disclosure[J]. Man ufacturing & Service Operations Management, 2023, 25(2): 543-562.
[22] NELSON P. Advertising as information[J]. Journal of political economy, 1974, 82(4): 729-754.
[23] GREEN B, TAYLOR C R. Breakthroughs, deadlines, and self-reported progress: Contractingfor multistage projects[J]. American Economic Review, 2016, 106(12): 3660-3699.
[24] REPULLO R, SUAREZ J. Venture capital finance: A security design approach[J]. Review of finance, 2004, 8(1): 75-108.