Wealth, the power to set terms, and the financing and control of firms
This dissertation analyzes the relationship between financiers and agents such as entrepreneurs operating small businesses who require finance to carry out their projects. It shows how the wealth agents invest in their projects and who has the power to set terms determine the financial contracts agents sign, who has ultimate control over projects, and how efficiently they are carried out.
Agents and financiers choose among three contracts: non-voting equity, voting equity, and debt. Non-voting equity simply gives financiers a share in returns from the project; voting equity and debt also give financiers the power to terminate agents' finance. Under debt, financiers terminate agents' loans if they fail to make timely payments—a simple but crude rule for termination. Under voting equity, financiers set performance standards, monitor agents, and decide whether to fire them. This ties dismissal to a more accurate assessment of agents' effort, but subjects agents to financiers' non-contractible choice of performance standards and may require costly monitoring. Whereas prevention of “shirking” by agents is the standard problem in theories of the firm, I show that agents may respond to termination threats by overworking.
When agents set the terms, the wealthiest agents issue non-voting equity, the less wealthy issue debt, and the least wealthy issue voting equity or cannot obtain finance. When financiers set terms, they demand voting equity from some agents who would have issued non-voting equity if they had set the terms. This may explain why financiers in highly concentrated financial systems take control of firms that would remain independent in a more competitive system.
Both agents and financiers set terms to maximize their own rents, even if this reduces the project's value. This contradicts traditional microeconomics, in which control rights are irrelevant, and models of incomplete contracts in which contracts are designed to maximize efficiency.
The efficiency of projects generally increases the more agents invest in them, but can decrease when agents set terms for voting equity. If agents are relatively wealthy, the efficiency of the project is greater when agents set the terms; if they are less wealthy, efficiency is greater when financiers set terms.