Theory and the Real World
Kaplan and Strömberg (2003)
Flow Rights (Principal-Agent Theory)
Rights (Incomplete Contract Theory)
Rights (Debt Theory)
Corporate Finance
© Professor Ho-Mou Wu
8A-1
Spring 2004
Principal-Agent Theory
Holmstrom (1979): Incentive Contracts
The manager exerts effort a, but only is observable. In order to overcome the moral hazard problem, an incentive compensation s(x) is provided (Handout 3A).
Under some general conditions, one can show that s’(x)>0. The incentive contract should also be contingent on as many signals correlated with effort as possible (the “Informativeness Principle” of Holmstrom).
Corporate Finance
Spring 2004
© Professor Ho-Mou Wu
8A-2
Principal-Agent Theory: Empirical Findings
These two implications of the principal-agent theory are supported by the empirical findings (Tables 2 and 3).
In addition, it is found that lower powered incentives are provided as asymmetric information declines, consistent with the principal-agent theory. (Repeat EN, months since the first financing round………).
Also, as performance signals become noisier, the contracts rely on vesting and lower liquidation cash flow rights.
8A-3
Spring 2004
Corporate Finance
© Professor Ho-Mou Wu
Incomplete Contract Theory
Aghion and Bolton (1992): Contingent Control
The entrepreneur receives private benefits while the investors receive only monetary returns. The conflicts of interest between EN and VC cannot be resolved through ex ante contracting. However, assigning contingent control rights provides a solution (Handout 5B).
As the external financing capacity decreases (the lower the profitability of the project, or the higher the conflicts of interest), control moves first from E control to contingent control and then to I control ( of Aghion and Bolton)
8A-4
Spring 2004
Corporate Finance
© Professor Ho-Mou Wu
Incomplete Contract Theory
Dewatripont and Tirole (1994): Optimal Correlation between cash flow rights and control rights with multiple securities.
It is better to have shareholder and creditor control (SC) since a single shareholder is not tough enough on management when intervention is costly (see Handout 5A).
When performance is poor, the party in control should have a cash flow claim that is concave in performance (such as debt), while when performance improves more control should be transferred to a holder of a convex cash flow claim (such as equity).
Corporate Finance
© Professor Ho-Mou Wu
8A-5
Spring 2004
Control Rights: Empirical Findings
Empirical findings support the theory: as agency problems and financial constraints become more severe, the control changes from EN control to state-contingent control (more elaborate than the debt contract) to VC control.
The contracts allocate cash flow rights, control rights and liquidation rights. The control rights shifts in different states, supportive of the incomplete contract theory.
© Professor Ho-Mou Wu
8A-6
Corporate Finance
Spring 2004
Control Rights: Empirical Findings
If the company performs poorly, the VCs obtain full control. As company performance improves, the ENs obtain more cash flow rights and control rights. If the company performs very well, the VCs relinquish most of their control and liquidation rights.
The allocation of these rights are contingent on many observable measures of company performance (more complicated than the theory predicts).
Corporate Finance
© Professor Ho-Mou Wu
Spring 2004
8A-7
Signaling Theory of Debt
Myers and Majluf (1984): debt has a higher pecking order than equity.
Assume that the manager maximize the value of old shareholders’ claims and that the capital market is efficient (and the old shareholders are passive…..). The manager with better information signals that success is more likely by offering a debt (with senior claims in liquidation).
Corporate Finance
Spring 2004
8A-8
© Professor Ho-Mou Wu
Liquidation Rights: Empirical Findings
If there is greater uncertainty about the project, we should observe stronger VC liquidation rights.
The empirical findings are not strong.
Corporate Finance
Spring 2004
8A-9
© Professor Ho-Mou Wu
Think More:
(a) The real-world contracts are more complex than existing theory predicts.
(b) The results will be different in emerging markets with imperfect capital markets.
Corporate Finance
Spring 2004
8A-10
© Professor Ho-Mou Wu
