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Incentive effects of funding contracts: an experiment

Published online by Cambridge University Press:  14 March 2025

J. Philipp Reiß  and
Irenaeus Wolff
J. Philipp Reiß*
Affiliation:
Institute of Economics (ECON), Karlsruhe Institute of Technology (KIT), Schlossbezirk 14, 76131 Karlsruhe, Germany
Irenaeus Wolff*
Affiliation:
TWI/University of Konstanz, Hauptstr. 90, 8280 Kreuzlingen, Switzerland
*
[email protected]
[email protected]
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Abstract

We examine the incentive effects of funding contracts on entrepreneurial effort and on allocative efficiency. We experiment with funding contracts that differ in the structure of investor repayment and, thus, in their incentives for the provision of entrepreneurial effort. Theoretically the replacement of a standard debt contract by a repayment-equivalent non-monotonic contract reduces effort distortions and increases efficiency. Likewise, distortions can be mitigated by replacing outside equity by a repayment-equivalent standard-debt contract. We test both hypotheses in the laboratory. Our results reveal that the incentive effects of funding contracts must be experienced before they are reflected in observed behavior. With sufficient experience, observed behavior is either consistent with or close to theoretical predictions and supports both hypotheses. If we allow for entrepreneur-sided manipulations of project outcomes, we find that non-monotonic contracts lose much of their appeal.

Keywords

Hidden informationFunding contractsIncentivesExperimentStandard debt contractNon-monotonic contractState manipulation

JEL classification

G21: Banks • Depository Institutions • Micro Finance Institutions • Mortgages C91: Laboratory, Individual Behavior D82: Asymmetric and Private Information • Mechanism Design
Type
Original Paper
Information
Experimental Economics , Volume 17 , Issue 4 , December 2014 , pp. 586 - 614
Copyright
Copyright © 2014 Economic Science Association

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Footnotes

Electronic Supplementary Material The online version of this article (doi:https://doi.org/10.1007/s10683-013-9385-5) contains supplementary material, which is available to authorized users.

Financial support from Maastricht University through METEOR is gratefully acknowledged. We thank Paul Smeets and audiences in Alicante (IMEBE2008), Caltech (ESA2008), Gothenburg (ESEM2013), Heidelberg, Luxembourg (GfEW2010), and Lyon (ESA2008) for helpful comments. The paper greatly benefited from helpful suggestions and comments of Jordi Brandts and two anonymous reviewers.

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