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

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

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

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

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

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

7. 7 Parameters

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

9. 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. 10 Application START UP "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 relatively few control rights (borrows from market, bank,...) relinquishes most control rights (borrows from venture capitalist,...)

11. 11 CONTINGENT CONTROL RIGHTS RAISE BORROWING CAPACITY B 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. 12 entrepreneur control and reward if high signal With a contingent action: investor control and no reward if low signal

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

14. 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. inaccurateunintuitive Yet, management has substantial say in these decisions. Reconciliation: formal and real authority.

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

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

17. 17 Ownership concentration and (active) monitoring:

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

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

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

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

22. 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.