capital to expand the firm.Myers and Majluf ignore perks,but suppose that the manager has better information about the profitability of the existing firm,i.e.,assets in place,than investors. In particular,imagine that the manager knows that these are worth a lot,whereas investors do not.Then,if the manager acts on behalf of current shareholders (e.g.,because he holds equity in the firm himself),he will not want to raise capital by issuing new shares.The reason is that the new shares will be sold at a discount relative to their true value,which dilutes the value of the current shareholders'stake. Instead the manager will raise capital by issuing (riskless)debt.Riskless debt will not sell at a discount-the firm will simply pay the market interest rate on it.Hence no dilution will take place.Thus Myers and Majluf provide another reason why MM fails:if managers have superior information,they will want to sell new securities whose return is insensitive to this information (riskless debt being the most insensitive security of all). Myers-Majluf are surely right that private information is an important determinant of financial structure,and the effect that they identify appears to be empirically significant. However,their analysis suffers from the same theoretical weakness as Jensen-Meckling.Financial structure matters only because managers are (implicitly)on a particular kind of incentive scheme. Specifically,Myers and Majluf assume that managers act on behalf of current shareholders,e.g., because they hold equity themselves.But things don't have to be this way.Suppose managers were paid a fraction of the firm's total market value V.Then managers wouldn't worry about selling new shares at a discount,since any loss in current shareholder value is offset by a gain in new shareholder value and managers are paid on the basis of the sum of the two.With this incentive scheme,managers are happy to expand by issuing new equity and financial structure no 8
8 capital to expand the firm. Myers and Majluf ignore perks, but suppose that the manager has better information about the profitability of the existing firm, i.e., assets in place, than investors. In particular, imagine that the manager knows that these are worth a lot, whereas investors do not. Then, if the manager acts on behalf of current shareholders (e.g., because he holds equity in the firm himself), he will not want to raise capital by issuing new shares. The reason is that the new shares will be sold at a discount relative to their true value, which dilutes the value of the current shareholders’ stake. Instead the manager will raise capital by issuing (riskless) debt. Riskless debt will not sell at a discount–the firm will simply pay the market interest rate on it. Hence no dilution will take place. Thus Myers and Majluf provide another reason why MM fails: if managers have superior information, they will want to sell new securities whose return is insensitive to this information (riskless debt being the most insensitive security of all). Myers-Majluf are surely right that private information is an important determinant of financial structure, and the effect that they identify appears to be empirically significant. However, their analysis suffers from the same theoretical weakness as Jensen-Meckling. Financial structure matters only because managers are (implicitly) on a particular kind of incentive scheme. Specifically, Myers and Majluf assume that managers act on behalf of current shareholders, e.g., because they hold equity themselves. But things don’t have to be this way. Suppose managers were paid a fraction of the firm’s total market value V. Then managers wouldn’t worry about selling new shares at a discount, since any loss in current shareholder value is offset by a gain in new shareholder value and managers are paid on the basis of the sum of the two. With this incentive scheme, managers are happy to expand by issuing new equity and financial structure no
longer matters. II.Financial Contracting Literature:Decision and Control Rights We have seen that incentive(agency)problems alone do not yield a very satisfactory theory of financial structure.The recent financial contracting literature(developed in the last fifteen years or so)adds a new ingredient to the stew:decision(control)rights.0 This literature takes as its starting point the idea that the relationship between an entrepreneur(or manager)and investors is dynamic rather than static.As the relationship develops over time,eventualities arise that could not easily have been foreseen or planned for in an initial deal or contract between the parties.For example,how many people in 1980 could have anticipated the fall of the Soviet Union or the rise of the Internet in the 1990s?In an ideal world, There is in fact a strict advantage to putting managers on an incentive scheme that rewards them according to total shareholder value,rather than current shareholder value.As Myers and Majluf show,the latter scheme may cause managers to turn down some profitable new projects,because the dilution effect on current shareholder value will be so great that they prefer not to invest.This inefficiency is avoided if managers are rewarded according to total shareholder value. John Persons(1994)argues that an incentive scheme where managers are paid a fraction of the firm's total market value is not "renegotiation-proof:the board of directors(acting on behalf of current shareholders)will always revise it.However,Persons does not explain why the board acts on behalf of current shareholders or why the board is given the power to revise the managerial incentive scheme. This recent literature should be contrasted with an earlier literature based on costly state verification;see Robert Townsend (1978)and Gale and Martin Hellwig(1985).In this earlier literature,an optimal contract between an entrepreneur and investor was analyzed under the assumption that a firm's profitability is private information,but that this information can be made public at a cost.This earlier literature did not stress contractual incompleteness(as defined below)or focus on the role of decision(control)rights. 9
9There is in fact a strict advantage to putting managers on an incentive scheme that rewards them according to total shareholder value, rather than current shareholder value. As Myers and Majluf show, the latter scheme may cause managers to turn down some profitable new projects, because the dilution effect on current shareholder value will be so great that they prefer not to invest. This inefficiency is avoided if managers are rewarded according to total shareholder value. John Persons (1994) argues that an incentive scheme where managers are paid a fraction of the firm’s total market value is not “renegotiation-proof”: the board of directors (acting on behalf of current shareholders) will always revise it. However, Persons does not explain why the board acts on behalf of current shareholders or why the board is given the power to revise the managerial incentive scheme. 10This recent literature should be contrasted with an earlier literature based on costly state verification; see Robert Townsend (1978) and Gale and Martin Hellwig (1985). In this earlier literature, an optimal contract between an entrepreneur and investor was analyzed under the assumption that a firm’s profitability is private information, but that this information can be made public at a cost. This earlier literature did not stress contractual incompleteness (as defined below) or focus on the role of decision (control) rights. 9 longer matters. 9 II. Financial Contracting Literature: Decision and Control Rights We have seen that incentive (agency) problems alone do not yield a very satisfactory theory of financial structure. The recent financial contracting literature (developed in the last fifteen years or so) adds a new ingredient to the stew: decision (control) rights. 10 This literature takes as its starting point the idea that the relationship between an entrepreneur (or manager) and investors is dynamic rather than static. As the relationship develops over time, eventualities arise that could not easily have been foreseen or planned for in an initial deal or contract between the parties. For example, how many people in 1980 could have anticipated the fall of the Soviet Union or the rise of the Internet in the 1990s? In an ideal world
a contract between a computer manufacturer(IBM,say)and a software producer(Microsoft), written in 1980,would have included a contingency about what would happen if the Internet took off or for that matter would have had a clause guarding against Microsoft from becoming the dominant supplier of operating systems.In practice,writing such a contingent contract would have been impossible:the future was simply too unclear. Economists(and lawyers)use the term"incomplete"to refer to a contract that does not lay out all the future contingencies.A key question that arises with respect to an incomplete contract is:how are future decisions taken?That is,given that an incomplete contract is silent about future eventualities,and given that important decisions must be taken in response to these eventualities,how will this be done?What decision-making process will be used? It might be helpful to give some examples.Consider a firm that has a long-term supplier. Advances in technology might make it sensible for the firm instead to buy its inputs on the Internet.Who makes the decision to switch? Or take a biotech firm that is engaged in trying to find a cure for diabetes.The firm has been pursuing a particular direction,but new research suggests that a different approach might be better.Who decides whether the firm should change strategy? Other examples concern whether a firm should undertake a new investment,whether the firm's CEO should be replaced,or whether the firm should be closed down. The financial contracting literature takes the view that,although the contracting parties cannot specify what decisions should be made as a function of(impossible)hard-to-anticipate- and-describe future contingencies,they can choose a decision-making process in advance.And one way they do this is through their choice of financial structure.Take equity.One feature of 10
10 a contract between a computer manufacturer (IBM, say) and a software producer (Microsoft), written in 1980, would have included a contingency about what would happen if the Internet took off–or for that matter would have had a clause guarding against Microsoft from becoming the dominant supplier of operating systems. In practice, writing such a contingent contract would have been impossible: the future was simply too unclear. Economists (and lawyers) use the term “incomplete” to refer to a contract that does not lay out all the future contingencies. A key question that arises with respect to an incomplete contract is: how are future decisions taken? That is, given that an incomplete contract is silent about future eventualities, and given that important decisions must be taken in response to these eventualities, how will this be done? What decision-making process will be used? It might be helpful to give some examples. Consider a firm that has a long-term supplier. Advances in technology might make it sensible for the firm instead to buy its inputs on the Internet. Who makes the decision to switch? Or take a biotech firm that is engaged in trying to find a cure for diabetes. The firm has been pursuing a particular direction, but new research suggests that a different approach might be better. Who decides whether the firm should change strategy? Other examples concern whether a firm should undertake a new investment, whether the firm’s CEO should be replaced, or whether the firm should be closed down. The financial contracting literature takes the view that, although the contracting parties cannot specify what decisions should be made as a function of (impossible) hard-to-anticipateand-describe future contingencies, they can choose a decision-making process in advance. And one way they do this is through their choice of financial structure. Take equity. One feature of
most equity is that it comes with votes.That is,equity-holders collectively have the right to choose the board of directors,which in turn has the (legal or formal)right to make key decisions in the firm-specifically,the kinds of decisions described above. In contrast,take debt.Creditors do not have the right to choose the board of directors or to take decisions in the firm directly.However,they have other rights.If a creditor is not repaid, she can seize or foreclose on the firm's assets or push the firm into bankruptcy.Moreover,if the firm enters bankruptcy,then creditors often acquire some of the powers of owners. A rough summary is that shareholders have decision rights as long as the firm is solvent, while creditors acquire decision rights in default states. It is worth emphasizing the difference between this perspective and that described in Part I.According to MM,the firm's cash flows are fixed and equity and debt are characterized by the nature of their claims on these cash flows:debt has a fixed claim while equity gets the residual.In Jensen and Meckling,the same is true except that now the allocation of cash flow claims can affect firm value through managerial incentives.In neither case do votes or decision rights matter. In contrast,in the financial contracting literature,decision rights or votes are key,even though,of course,as we shall see,cash flow rights matter a lot too. It is also worth noting that there is an important distinction between the kinds of decisions we are talking about here and the managerial actions we discussed in the context of Jensen- Meckling.Managerial actions,e.g.,the level of perks or effort,are usually assumed to be nontransferable (or hard to transfer):only the manager can choose them.In contrast,decision rights are (more easily)transferable:e.g.,the decision about whether to replace the CEO,say,can be taken by one party(shareholders)or by another party (creditors).Hence,a key design 11
11 most equity is that it comes with votes. That is, equity-holders collectively have the right to choose the board of directors, which in turn has the (legal or formal) right to make key decisions in the firm–specifically, the kinds of decisions described above. In contrast, take debt. Creditors do not have the right to choose the board of directors or to take decisions in the firm directly. However, they have other rights. If a creditor is not repaid, she can seize or foreclose on the firm’s assets or push the firm into bankruptcy. Moreover, if the firm enters bankruptcy, then creditors often acquire some of the powers of owners. A rough summary is that shareholders have decision rights as long as the firm is solvent, while creditors acquire decision rights in default states. It is worth emphasizing the difference between this perspective and that described in Part I. According to MM, the firm’s cash flows are fixed and equity and debt are characterized by the nature of their claims on these cash flows: debt has a fixed claim while equity gets the residual. In Jensen and Meckling, the same is true except that now the allocation of cash flow claims can affect firm value through managerial incentives. In neither case do votes or decision rights matter. In contrast, in the financial contracting literature, decision rights or votes are key, even though, of course, as we shall see, cash flow rights matter a lot too. It is also worth noting that there is an important distinction between the kinds of decisions we are talking about here and the managerial actions we discussed in the context of JensenMeckling. Managerial actions, e.g., the level of perks or effort, are usually assumed to be nontransferable (or hard to transfer): only the manager can choose them. In contrast, decision rights are (more easily) transferable: e.g., the decision about whether to replace the CEO, say, can be taken by one party (shareholders) or by another party (creditors). Hence, a key design
question is:how should decision rights be allocated in the initial contract/deal between the parties?To this we now turn. The Allocation of Decision Rights The financial contracting literature has tended to focus on small entrepreneurial firms-rather than a publicly traded company or corporation-and we will do this too for the moment.To make things very simple,consider a single entrepreneur,a single investor,and a single project.The question is,how should the right to make future decisions be allocated between the entrepreneur and the investor?Who should have the right to replace the CEO or terminate the project? In order to answer this question,we obviously need a theory of why the allocation of decision-making authority matters.Various possibilities have been advanced.One approach is based on the idea that decision rights are important for influencing asset-or relationship-specific investments.Suppose individual i is considering whether to invest resources in learning about how to make the project more profitable.If he controls the project,and has a good idea,he can implement this idea without interference from anyone else.This gives him a strong incentive to have an idea.On the other hand,if someone else controls the project,i will have to get permission from this other person and may have to share the fruits of his idea with them;this will dilute his incentives. The above approach has been used in the theory of the firm but has been employed less in the financial contracting literature.Instead,in this latter literature,researchers have focused on See Sanford Grossman and Hart(1986),Hart and John Moore (1990),and Hart(1995). 12
11See Sanford Grossman and Hart (1986), Hart and John Moore (1990), and Hart (1995). 12 question is: how should decision rights be allocated in the initial contract/deal between the parties? To this we now turn. The Allocation of Decision Rights The financial contracting literature has tended to focus on small entrepreneurial firms–rather than a publicly traded company or corporation–and we will do this too for the moment. To make things very simple, consider a single entrepreneur, a single investor, and a single project. The question is, how should the right to make future decisions be allocated between the entrepreneur and the investor? Who should have the right to replace the CEO or terminate the project? In order to answer this question, we obviously need a theory of why the allocation of decision-making authority matters. Various possibilities have been advanced. One approach is based on the idea that decision rights are important for influencing asset- or relationship-specific investments. Suppose individual i is considering whether to invest resources in learning about how to make the project more profitable. If he controls the project, and has a good idea, he can implement this idea without interference from anyone else. This gives him a strong incentive to have an idea. On the other hand, if someone else controls the project, i will have to get permission from this other person and may have to share the fruits of his idea with them; this will dilute his incentives. The above approach has been used in the theory of the firm 11 but has been employed less in the financial contracting literature. Instead, in this latter literature, researchers have focused on