DECISION RIGHTS AND CORPORATE
CONTROL
5th set of transparencies for ToCF
I. INTRODUCTION
Control right / Authority
between
investors and
entrepreneur?
FORMAL
allocation
among investors
why
REAL
equityholders in
good times
debtholders in
bad times?
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
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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
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entrepreneur decides
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
not take painful (profit-enhancing) action.
Either A large
does
and then entrepreneur
retains control
Or A not sufficient to attract financing, then (if  not too large)
investor control
second-best optimal.
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Reminiscent of costly collateral pledging!
ONE ARGUMENT IN FAVOR OF "SHAREHOLDER VALUE"
[First-best efficient action
two reasons for investor control].
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STRENGTH OF BORROWER’ S BALANCE SHEET
no funding
entrepreneur
relinquishes
control
entrepreneur
retains control
A
MULTIPLE CONTROL RIGHTS:  ST decisions
 collaborators
 LT investment
 managerial
compensation
etc.
K control rights
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Parameters
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Case #1 (uninteresting)
relinquish only efficient ones.
Case #2 (capital constraint)
(maximizes pledgeable income)
Entrepreneur keeps control rights for which
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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.
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START UP
Application
"BORROWS
AGAINST
ASSETS"
Firm with
strong balance
sheet
 cash (A)
 collateral
some safe income stream
 low private benefit
relinquishes
relatively few
control rights
(borrows from
market, bank,...)
"BORROWS
AGAINST
INCOME"
Firm with
weak balance
sheet
 no cash
 no collateral
 no safe income stream
relinquishes most
control rights
(borrows from
venture
capitalist,...)
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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
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• With a contingent action:
investor control and no reward if low
signal
entrepreneur control and reward if high
signal
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Pledgeable income:
Pledgeable income under noncontingent investor control:
is smaller if
(interesting case)
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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.
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Issue with approach of directly assuming management has formal
rights:
 which rights,
 when real authority?
[ depends on CORPORATE GOVERNANCE!]
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INTUITIVE APPROACH
 n ex ante identical actions, plus status quo (0,0)
 only 1 action is "relevant" (others bad)
identity not known ex ante
furthermore
and
Suppose entrepreneur
 relevant action


(b) proposes the action.
Uninformed investors rubberstamp iff
(a) learns
(say, stronger balance sheet)
more likely to rubberstamp.
Otherwise deadlock.
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 Ownership concentration and (active) monitoring:
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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
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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.
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MULTIPLE SECURITIES AND OUTSIDE EQUITY
COSTS WELL UNDERSTOOD: Externalities among investors
(Jensen-Meckling 1976).
Debtholders’
payoff
D
D
SHAREHOLDERS
(OUTSIDE EQUITY)
profit
CREDITORS
INSIDERS
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MULTIPLE SECURITIES AS A DISCIPLINING DEVICE
FIRST
EFFORT
INTERMEDIATE
PROFIT
SECOND EFFORT
(CHOICE OF p)
LIQUIDATION,
DOWNSIZING
FINAL
OUTCOME
R
0
p
1-p
L
POOR INTERMEDIATE PERFORMANCE
DEBT CONTROL
LIQUIDATION, INTERFERENCE
FAIR INTERMEDIATE PERFORMANCE
EQUITY CONTROL
CONTINUATION
(Dewatripont-Tirole 1994)
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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.
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