DECISION RIGHTS AND CORPORATE CONTROL 5th set of transparencies for ToCF

1. DECISION RIGHTS AND CORPORATE CONTROL 5th set of transparencies for ToCF

2. I. INTRODUCTION Control right / Authority FORMAL allocation equityholders in good times between investors and entrepreneur? among investors why debtholders in bad times? REAL Private information confers some (how much?) real authority even if no formal authority.  Why do managers have so much control? When do they have much control? Why do minority block shareholders have so much control? Informational asymmetry Need for cooperation

3. II. ALLOCATION OF FORMAL AUTHORITY (Reinterpretation of) Aghion-Bolton 1992 RELINQUISHING CONTROL RIGHTS TO INVESTORS INCREASES PLEDGEABLE INCOME AND THUS BOOSTS DEBT CAPACITY. Example: Fixed investment model  Action non describable, can’t be contracted upon; but can allocate control right investors decide entrepreneur decides

4. Suppose action is first-best inefficient: Investors control: bear none of select profit-enhancing action. Entrepreneur control: bears all of  receives only part of R does not take painful (profit-enhancing) action. Either A large and then entrepreneur retains control Or A not sufficient to attract financing, then (if  not too large) investor control second-best optimal.

5. Reminiscent of costly collateral pledging! ONE ARGUMENT IN FAVOR OF "SHAREHOLDER VALUE" [First-best efficient action two reasons for investor control].

6. STRENGTH OF BORROWER’ S BALANCE SHEET A entrepreneur retains control entrepreneur relinquishes control no funding MULTIPLE CONTROL RIGHTS:  ST decisions  collaborators  LT investment  managerial compensation etc. K control rights

7. Parameters

8. Case #1 (uninteresting) relinquish only efficient ones. Case #2 (capital constraint) (maximizes pledgeable income) Entrepreneur keeps control rights for which

9. Principle of relative willingness to pay for control right (pledge less costly / more redeployable assets first = analogy): Surrender all control rights for which investor control is FB optimal, plus some others.

10. START UP Application "BORROWS AGAINST ASSETS" "BORROWS AGAINST INCOME" Firm with strong balance sheet Firm with weak balance sheet  cash (A)  collateral some safe income stream  low private benefit  no cash  no collateral  no safe income stream relinquishes most control rights (borrows from venture capitalist,...) relinquishes relatively few control rights (borrows from market, bank,...)

11. B CONTINGENT CONTROL RIGHTS RAISE BORROWING CAPACITY Combined with signal (e.g., ST profit): In the absence of action (or with a noncontingent action): (if signal sufficient statistic). • With a contingent action: entrepreneur control and reward if high signal

12. With a contingent action: investor control and no reward if low signal entrepreneur control and reward if high signal

13. Pledgeable income: Pledgeable income under noncontingent investor control: is smaller if (interesting case)

14. III. REAL AUTHORITY Theory often assumes that management has formal right to choose:  investment  dividends / retained earnings  debt / financial structure  next manager when departing CEO  takeover defenses  etc. inaccurate unintuitive Yet, management has substantial say in these decisions. Reconciliation: formal and real authority.

15.  which rights,  when real authority? [ depends on CORPORATE GOVERNANCE!] Issue with approach of directly assuming management has formal rights:

16. INTUITIVE APPROACH nex ante identical actions, plus status quo (0,0)  only 1 action is "relevant" (others bad) identity not known ex ante furthermore and Suppose entrepreneur (a) learns  relevant action     (b) proposes the action. Uninformed investors rubberstamp iff (say, stronger balance sheet) more likely to rubberstamp. Otherwise deadlock.

17.  Ownership concentration and (active) monitoring:

18. STRENGTH OF BALANCE SHEET AND CORPORATE GOVERNANCE Arm’s lengh relationship (no active monitor) if investors rubberstamp. (extra term  0 by definition: ) rubberstamping A STRONGER BALANCE SHEET LEADS TO A LESS CONFLICTUAL RELATIONSHIP

19. Relationshiplending active monitor has same information as entrepreneur Suppose cost c > 0: criterion: independent of A. (second reason for why) relationship lending covaries positively with weakness of balance sheet.

20. MULTIPLE SECURITIES AND OUTSIDE EQUITY COSTS WELL UNDERSTOOD: Externalities among investors (Jensen-Meckling 1976). Debtholders’ payoff D D profit SHAREHOLDERS (OUTSIDE EQUITY) CREDITORS INSIDERS

21. MULTIPLE SECURITIES AS A DISCIPLINING DEVICE FINAL OUTCOME FIRST EFFORT INTERMEDIATE PROFIT SECOND EFFORT (CHOICE OF p) I LIQUIDATION, DOWNSIZING R p 0 1-p L POOR INTERMEDIATE PERFORMANCE DEBT CONTROL LIQUIDATION, INTERFERENCE FAIR INTERMEDIATE PERFORMANCE EQUITY CONTROL CONTINUATION (Dewatripont-Tirole 1994)

22. Dewatripont’s puzzle : Tension between Design of multiple securities in the first place Facilitating renegotiation among investors Bondholder trustee and exchange offer institutions. Literature on bankruptcy.