1. © Cumming & Johan (2013)Agency Problems Cumming & Johan (2013, Chapter 2) 1

2. © Cumming & Johan (2013)Agency Problems Chapter Objectives Forms of finance Agency problems Differences across securities 2

3. © Cumming & Johan (2013)Agency Problems Forms of Finance Debt  1 st priority in bankruptcy  Stipulated interest payments  Non-payment of interest  can force bankruptcy Preferred Equity  2 nd priority in bankruptcy  Stipulated preferred dividend payments  Non-payment of dividends  cannot force bankruptcy Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 3

4. © Cumming & Johan (2013)Agency Problems Forms of Finance (Con’t) Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary Common Equity  Last priority in bankruptcy  Dividends may or may not be forthcoming  Residual claimants  upside potential  capital gains! Warrants  Option to purchase common equity  Like an American call option to purchase the firm (but different because increases # securities when exercised) 4

5. © Cumming & Johan (2013)Agency Problems Forms of Finance (Con’t) Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary Convertible debt  Debt + option to convert from debt to common equity  Similar to debt + warrants Convertible preferred equity  Preferred equity + option to convert from preferred equity to common equity  Similar to preferred equity + warrants 5

6. © Cumming & Johan (2013)Agency Problems Figure 2.1. Payoff Functions $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity 45 o Present Value of Interest + Principal on Debt Present Value of Pre-Specified Preferred Dividends Slope is 45 o for 100% of the common shares (45 o * X/100 for X% of the common shares) 6

7. © Cumming & Johan (2013)Agency Problems Figure 2.2. Payoff Function for Convertible Security $ Value of Entrepreneurial Firm Payoff to Convertible Security 45 o 7

8. © Cumming & Johan (2013)Agency Problems Agency Theory Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary High risks and informational asymmetries in venture capital finance lead to problems of:  Moral Hazard  Adverse Selection  Free Riding  Hold-up  Trilateral Bargaining  Window Dressing  Among other problems… 8

9. © Cumming & Johan (2013)Agency Problems Chapter 2 theory used throughout book Chapter 2 forms the basis for all subsequent chapters Part II Chapters 4-9: agency problems in fund management Part III Chapters 10-14 and Part IV Chapters 15-18: agency problems in relationships with entrepreneurs Part V Chapters 19-22: agency problems in exiting investments Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 9

10. © Cumming & Johan (2013)Agency Problems Principal  Agent (8 agency relationships here) Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary Venture Capitalist 1Venture Capitalist 2 Entrepreneur Investors Figure 2.3. Principal  Agent Relationships in Venture Capital 10

11. © Cumming & Johan (2013)Agency Problems Principal  Agent (8 agency relationships here) Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary PrincipalAgent 1.Investor 1Venture Capitalist 1 2.Investor 2Venture Capitalist 2 3.Venture Capitalist 1Entrepreneur 4.Venture Capitalist 2Entrepreneur 5.EntrepreneurVenture Capitalist 1 6.EntrepreneurVenture Capitalist 2 7.Venture Capitalist 1Venture Capitalist 2 8.Venture Capitalist 2Venture Capitalist 1 11

12. © Cumming & Johan (2013)Agency Problems Moral Hazard Effort of each party affects the expected value of the entrepreneurial venture Cannot write a contract on effort (effort is observable but not verifiable) Incentive to maximize effort is an increasing function of an agent’s residual claim to the entrepreneurial venture Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 12

13. © Cumming & Johan (2013)Agency Problems Multitask Moral Hazard Less likely to act in the interests of someone with whom you have contracted with when you have other better things to do! Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 13

14. © Cumming & Johan (2013)Agency Problems Bilateral Moral Hazard Principal  Agent Each act as both principal and agent Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 14

15. © Cumming & Johan (2013)Agency Problems Adverse Selection Assume project qualities are distributed such that expected value from all projects is the same (same 1 st moments), but some projects are riskier than others (different 2 nd moments) Offers of debt financing attracts riskier projects than offers of equity financing Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 15

16. © Cumming & Johan (2013)Agency Problems ProbabilityProbability Value of Entrepreneurial Firm Entrepreneur 1: “NUT” Entrepreneur 2 “Heads I win” Entrepreneur 1 gets upside of all equity when investor has debt “Tails you lose” Entrepreneur 1 does not bear cost; debt investor does. Entrepreneur 2 relatively smaller expected cost of giving up equity $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity Figure 2.4. “Debt Attracts Nuts” Point A. Entrepreneur 3 lower expected cost of giving up equity to investor 16

17. © Cumming & Johan (2013)Agency Problems Adverse Selection (Continued) Assume project qualities are distributed such that expected value from all projects is the different (different 1 st moments), but all projects have the same 2 nd moments Offers of equity financing attracts riskier projects than offers of debt financing Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 17

18. © Cumming & Johan (2013)Agency Problems ProbabilityProbability Value of Entrepreneurial Firm Entrepreneur 3: “Lemon” Entrepreneur 4 Figure 2.5. “Equity Attracts Lemons” Entrepreneur 3 Incentives to give equity to investor to help shift distribution right $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity Point A. Entrepreneur 3 lower expected cost of giving up equity to investor Point C. Entrepreneur 3 bankruptcy and permanent loss of control associated with investor debt Point A. Entrepreneur 3 lower expected cost of giving up equity to investor Point B. Entrepreneur 4 high expected cost of giving up equity to investor Value of Entrepreneurial Firm 18

19. © Cumming & Johan (2013)Agency Problems Free Riding Consider a syndicated venture capital investment Effort of each venture capitalist is substitutable Each venture capitalist has an incentive to “free ride” off the effort of the other venture capitalist Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 19

20. © Cumming & Johan (2013)Agency Problems Hold-up Consider a staged and non-syndicated venture capital investment contract What happens if the venture capitalist decides s/he wants to renegotiate the terms of the contract? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 20

21. © Cumming & Johan (2013)Agency Problems Trilateral Bargaining Consider a non-syndicated venture capital investment Suppose the entrepreneur has control over the firm Will the entrepreneur ever want to give up control over the firm to a third party? What will the implications be for the initial venture capital investor? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 21

22. © Cumming & Johan (2013)Agency Problems Window Dressing Consider a staged venture capital investment At each performance review, what are the incentives of the entrepreneur? How might this affect the optimal continuation decision and the value of the firm in the long-run? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 22

23. © Cumming & Johan (2013)Agency Problems Some Agency Problems with Debt Risk Shifting Underinvestment Asset stripping Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 23

24. © Cumming & Johan (2013)Agency Problems Some Agency Problems with Debt Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary Figure 2.6. Agency Problem of Underinvestment $ Value of Entrepreneurial Firm Payoff to Debt 45 o A B 24

25. © Cumming & Johan (2013)Agency Problems Some Agency Problems with Debt Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary Figure 2.7. Agency Problem of Asset Stripping $ Value of Entrepreneurial Firm Payoff to Debt 45 o A C B 25

26. © Cumming & Johan (2013)Agency Problems Banks? Agency costs explain reluctance of banks to finance entrepreneurial firms  Regulations inhibit the ability of banks to hold equity  Bankers typically do not have the time or skill set (?) to screen and monitor entrepreneurial loans where there is little collateral  Incentive scheme for bankers (fixed fees) different than that for venture capitalists (residual fees  encourage effort & risk- taking) Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 26

27. © Cumming & Johan (2013)Agency Problems Question What explains the market for venture capitalists? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 27

28. © Cumming & Johan (2013)Agency Problems When Should We Care About Agency Costs? Market Uncertainty Entrepreneurial Quality Uncertainty (“Asymmetric Information”) Technology  Asset Intangibility Firm Development Stages Amount Invested and Investment Specificity Number of Firm Employees Firm’s Operating Activities Supply of and Demand for Venture Capital Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 28

29. © Cumming & Johan (2013)Agency Problems When Should We Care About Agency Costs? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary FIRMVALUEFIRMVALUE Modigliani and Miller (1958) [no taxes] Miller and Modigliani (1963) [debt tax shields] Jensen and Meckling (1976) [agency costs] Optimal Capital Structure Figure 2.8 Capital Structure and Firm Value 29

30. © Cumming & Johan (2013)Agency Problems When Should We Care About Agency Costs? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary FIRMVALUEFIRMVALUE No agency costs and no monitoring & transactions costs Optimal Staging Frequency Figure 2.9 Staged Venture Capital Investments and Firm Value Staging Frequency No agency costs but monitoring & transactions costs 30

31. © Cumming & Johan (2013)Agency Problems Summary Agency problems in all aspects of VC and PE investment In this course we consider ways to mitigate agency problems through  Fund structures  Contracts, Forms of finance  Staging, syndication  Exit strategies Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 31

32. © Cumming & Johan (2013)Agency Problems Summary Important questions: Can you eliminate or just mitigate agency problems in VC and PE finance? Does mitigating one type of agency problem exacerbate another types of agency problem? Forms of Finance Agency Problems Defined Why Care About Agency Problems Summary 32