The Simple Analytics of Informed Finance

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Abstract
The paper derives two analytical consequences of informed finance: Equity leads to under-financing, while debt leads to over-financing. We show that our model can explain key qualitative and quantitative features of informed venture capital finance in the United States. Using only four model parameters we match: (1) the venture capitalist's equity share; (2) the venture capitalist's expected return and (3) its standard deviation; (4) the probability that a project receives funding; and (5) the probability the venture capitalist loses money on an investment. Our estimated parameters reveal the average quality of an unfunded project; the percentage of uncertainty resolved by the venture capitalists investigation; the percentage of total surplus accruing to the venture capitalist, and the magnitude of underfinancing associated with venture capital finance.

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