Financial Contracting and the Specialization of Assets∗

We analyze the nature of financial contracting when an entrepreneur can choose the specificity of investments and financial contracts are incomplete. Investing in projectspecific assets increases productivity but decreases liquidation value. This creates a strategic incentive to specialize assets to decrease the bargaining power of the financier when debt financing is used. By contrast, equity financing provided by a financier who contributes to the project may be feasible because his contribution becomes more valuable as assets become more specialized. This helps persuade the entrepreneur to take the firm public, making cash flows contractible and allowing the financier to cash out. The entrepreneur faces a tension between going public, which is costly but induces the financier to exert effort, and remaining private, which limits the opportunities for contracting but allows the entrepreneur to divert cash flows. We predict that firms with greater opportunity to specialize will be mostly financed by equity, which results in optimal investment and exit decisions.