how the allocation of control rights affects the trade-off between cash flows and private benefits once the relationship is underway. The best known paper adopting this approach is Philippe Aghion and Patrick Bolton (1992).2 Aghion and Bolton assume that the project yields cash flows in the amount of $V and private benefits in the amount of $B.Private benefits are similar to the non-pecuniary benefits discussed in Jensen-Meckling;although private benefits may represent things like psychic value, we suppose that they have a cash equivalent,i.e.,they can be measured in dollars.The investor is interested only in cash flows,while the entrepreneur is interested in both cash flows and private benefits.These different interests create a potential conflict between the entrepreneur and investor. Since private benefits(like decision rights)are very important in what follows,it may help to illustrate them.Consider an entrepreneur who has developed an idea for a project.The entrepreneur is likely to get some personal satisfaction from working on the project,or from the project succeeding,that is over and above any cash flows received.Also,if the project succeeds, the entrepreneur's reputation is enhanced and he will do better in future deals.Personal satisfaction and reputational enhancement are both examples of private benefits since they are enjoyed by the entrepreneur but not the investor. Some private benefits are less innocuous.Someone who controls a project can decide who will work on the project;the controller may choose to appoint relatives or friends to key positions even though they are incompetent("patronage").The controller may also be able to For related work,see Bolton and David Scharfstein(1990),Douglas W.Diamond (1991),Hart and Moore (1994)and Hart and Moore(1998). 13
12For related work, see Bolton and David Scharfstein (1990), Douglas W. Diamond (1991), Hart and Moore (1994) and Hart and Moore (1998). 13 how the allocation of control rights affects the trade-off between cash flows and private benefits once the relationship is underway. The best known paper adopting this approach is Philippe Aghion and Patrick Bolton (1992). 12 Aghion and Bolton assume that the project yields cash flows in the amount of $V and private benefits in the amount of $B. Private benefits are similar to the non-pecuniary benefits discussed in Jensen-Meckling; although private benefits may represent things like psychic value, we suppose that they have a cash equivalent, i.e., they can be measured in dollars. The investor is interested only in cash flows, while the entrepreneur is interested in both cash flows and private benefits. These different interests create a potential conflict between the entrepreneur and investor. Since private benefits (like decision rights) are very important in what follows, it may help to illustrate them. Consider an entrepreneur who has developed an idea for a project. The entrepreneur is likely to get some personal satisfaction from working on the project, or from the project succeeding, that is over and above any cash flows received. Also, if the project succeeds, the entrepreneur’s reputation is enhanced and he will do better in future deals. Personal satisfaction and reputational enhancement are both examples of private benefits since they are enjoyed by the entrepreneur but not the investor. Some private benefits are less innocuous. Someone who controls a project can decide who will work on the project; the controller may choose to appoint relatives or friends to key positions even though they are incompetent (“patronage”). The controller may also be able to
divert money from the project,e.g.,he can set up other firms that he has an ownership interest in, and choose the terms of trade between the project and these firms to suck cash out of the project. Patronage and diversion are also examples of private benefits. As noted,the existence of private benefits introduces a potential conflict of interest between the entrepreneur and the investor.How is this conflict resolved?The answer is that this depends to a large extent on who has the right to make decisions once the relationship is underway. To understand this,consider a simple case where the entrepreneur is allocated a fraction 0 of the project cash flows and the investor receives the remaining(1-0).Suppose that the project is set up at date 0 and all decisions are taken and benefits earned at date 1.The date 1 objective functions of the entrepreneur and investor are then as follows: Entrepreneur:Max B+0V Investor: Max (1-0)V Max V It is also useful to write down the objective of a planner who is concerned with social(or Pareto)efficiency.In a first-best world where lump sum distributions are possible the planner would maximize the sum of the entrepreneur and investor's payoffs(since both are measured in money),i.e.,social surplus,B+V. Social Planner: B+V 14
14 divert money from the project, e.g., he can set up other firms that he has an ownership interest in, and choose the terms of trade between the project and these firms to suck cash out of the project. Patronage and diversion are also examples of private benefits. As noted, the existence of private benefits introduces a potential conflict of interest between the entrepreneur and the investor. How is this conflict resolved? The answer is that this depends to a large extent on who has the right to make decisions once the relationship is underway. To understand this, consider a simple case where the entrepreneur is allocated a fraction of the project cash flows and the investor receives the remaining (1 - ). Suppose that the project is set up at date 0 and all decisions are taken and benefits earned at date 1. The date 1 objective functions of the entrepreneur and investor are then as follows: Entrepreneur: Max B + V Investor: Max (1 - )V Max V It is also useful to write down the objective of a planner who is concerned with social (or Pareto) efficiency. In a first-best world where lump sum distributions are possible the planner would maximize the sum of the entrepreneur and investor’s payoffs (since both are measured in money), i.e., social surplus, B + V. Social Planner: B + V