Most informal finance comes from family and friends. Existing informal finance theories cannot match two characteristics of family finance: family investors may accept belowmarket or even negative returns, yet borrowers often prefer formal finance. We argue that social preferences make family finance cheap but create shadow costs that nonetheless discourage its use: Committing family funds to risky investment displaces intrafamily insurance and undermines limited liability. The same characteristics that sustain familial insurance thus render family finance a poor source of risk capital. Even when overcoming capital constraints requires social ties, intermediation and semiformalization may therefore be crucial for promoting risk taking.

We study transactions in which sellers fear being underpaid because their outside option is better known to the buyer. We rationalize various observed contracts as solutions to such smart buyer problems. Key to these solutions is granting the seller upside participation. In contrast, the lemons problem calls for granting the buyer downside protection. But, in either case, the seller (buyer) receives a convex (concave) claim. Thus, contracts usually associated with the lemons problem, such as debt or cash-equity offers, can be equally well manifestations of the smart buyer problem, although the two information asymmetries have opposite cross-sectional implications. Received December 23, 2014; accepted May 23, 2016 by Editor Uday Rajan.

Financing from family and friends is the predominant type of informal finance. This paper proposes a theory that reconciles two seemingly paradoxical traits of this form of finance, namely, it is often provided at negative prices but nevertheless eschewed by borrowers. A central prediction is that such finance, while breeding trust, deters risk taking. Demand is thus constrained: entrepreneurs may forgo risky investment rather than finance it through family and friends. Formal finance is valuable precisely because it is regulated only by contract. The highlighted trade-offs between formal and informal finance are potentially relevant for the provision of microventure capital.