Financing and corporate growth under repeated moral hazard

Anderson, R W and Nyborg, K G (2000) Financing and corporate growth under repeated moral hazard. Working Paper. London Business School IFA Working Paper.

Abstract

This paper considers the impact of ficial contracting on growth by exploring a model where entrepreneurs initially do R&D but subsequently need both outside investors to provide funds for capital investments and outside managers to operate the firm efficiently some time after assets are in place. The source of contracting inefficiency is that insiders can divert cash flows for their own benefit. We employ a repeated game framework, which allows us to model outside equity as well as inside equity and debt. We call our framework the twostage model of firm growth. A key finding is that outside equity promotes ex post efficiency (second stage growth) at the expense of ex ante efficiency (first stage growth), while debt works the opposite way. This is because equity promotes replacement of the entrepreneur, while debt promotes entrenchment. So debt has the disadvantage that it is less conducive to the implementation of second stage growth than equity, but the advantage that it provides the entrepreneur with more incentives to do R&D in the first place. Furthermore, equity is fragile, in the sense that moral hazard may be so high that investors will not fice the firm, regardless of the discount rate. In contrast, debt ficing definitely can be raised for low discount rates. A prediction of the model is that in a crosssection of firms, we should observe a preponderance of highly levered, closelyheld firms which have stagnated after an early growth phase.