Entrepreneurial Financing and Costly Due Diligence

In the traditional solution to the adverse selection problem, entrepreneurs indirectly signal quality via security choice, typically debt. This paper models an alternative solution. The costly due diligence of venture capitalists directly reveals the quality of projects, thereby reducing information asymmetry. It is shown that this mechanism necessitates profit-sharing, a contractual feature usually associated in the literature with managerial agency costs rather than adverse selection.