On Breakthroughs, Deadlines, and the Nature of Progress: Optimal Contracts for Multistage Projects∗

We study the optimal incentive scheme for a project with two stages in which a risk-neutral agent, protected by limited liability, can divert resources for private benefit. Staged financing, pervasive in both venture capital and funding research, arises as a feature of the optimal contract. The nature of progress (i.e., successful completion of the first stage) plays an important role. When progress is tangible (observable and contractible), optimal incentives are provided through a sequence of deadlines and a reward scheme that decreases over time. Early progress in the first stage gives the agent more time to complete the second one. When progress is intangible (privately observed by the agent), unverifiable “progress reports” are required to implement the optimal contract even though the information in the report has no social value. The optimal contract involves a “soft deadline” wherein the principal guarantees funding up to a certain date – if the agent reports progress at that date, then the principal gives him another round of funding to complete the project – if not, then a “probationary” phase begins in which the project is terminated at a constant rate until progress is reported. We explore the implications for welfare, the likelihood of project success and optimal project design. JEL Classification: J41, L14, M55, D82