Chapter 2

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Chapter 2

  1. 1. Agency Problems <ul><li>Cumming & Johan (2009, Chapter 2) </li></ul>
  2. 2. Chapter Objectives <ul><li>Forms of finance </li></ul><ul><li>Agency problems </li></ul><ul><li>Differences across securities </li></ul>
  3. 3. Forms of Finance <ul><li>Debt </li></ul><ul><ul><li>1 st priority in bankruptcy </li></ul></ul><ul><ul><li>Stipulated interest payments </li></ul></ul><ul><ul><li>Non-payment of interest  can force bankruptcy </li></ul></ul><ul><li>Preferred Equity </li></ul><ul><ul><li>2 nd priority in bankruptcy </li></ul></ul><ul><ul><li>Stipulated preferred dividend payments </li></ul></ul><ul><ul><li>Non-payment of dividends  cannot force bankruptcy </li></ul></ul><ul><li>Forms of Finance </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  4. 4. Forms of Finance (Con’t) <ul><li>Forms of Finance </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul><ul><li>Common Equity </li></ul><ul><ul><li>Last priority in bankruptcy </li></ul></ul><ul><ul><li>Dividends may or may not be forthcoming </li></ul></ul><ul><ul><li>Residual claimants  upside potential  capital gains! </li></ul></ul><ul><li>Warrants </li></ul><ul><ul><li>Option to purchase common equity </li></ul></ul><ul><ul><li>Like an American call option to purchase the firm (but different because increases # securities when exercised) </li></ul></ul>
  5. 5. Forms of Finance (Con’t) <ul><li>Forms of Finance </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul><ul><li>Convertible debt </li></ul><ul><ul><li>Debt + option to convert from debt to common equity </li></ul></ul><ul><ul><li>Similar to debt + warrants </li></ul></ul><ul><li>Convertible preferred equity </li></ul><ul><ul><li>Preferred equity + option to convert from preferred equity to common equity </li></ul></ul><ul><ul><li>Similar to preferred equity + warrants </li></ul></ul>
  6. 6. Figure 2.1. Payoff Functions $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity 45 o 45 o 45 o Present Value of Interest + Principal on Debt Present Value of Pre-Specified Preferred Dividends Slope is 45 o for 100% of the common shares (45 o * X/100 for X% of the common shares)
  7. 7. Figure 2.2. Payoff Function for Convertible Security $ Value of Entrepreneurial Firm Payoff to Convertible Security 45 o
  8. 8. Agency Theory <ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul><ul><li>High risks and informational asymmetries in venture capital finance lead to problems of: </li></ul><ul><ul><li>Moral Hazard </li></ul></ul><ul><ul><li>Adverse Selection </li></ul></ul><ul><ul><li>Free Riding </li></ul></ul><ul><ul><li>Hold-up </li></ul></ul><ul><ul><li>Trilateral Bargaining </li></ul></ul><ul><ul><li>Window Dressing </li></ul></ul><ul><ul><li>Among other problems… </li></ul></ul>
  9. 9. Chapter 2 theory used throughout book <ul><ul><li>Chapter 2 forms the basis for all subsequent chapters </li></ul></ul><ul><ul><ul><li>Part II Chapters 4-9: agency problems in fund management </li></ul></ul></ul><ul><ul><ul><li>Part III Chapters 10-14 and Part IV Chapters 15-18: agency problems in relationships with entrepreneurs </li></ul></ul></ul><ul><ul><ul><li>Part V Chapters 19-22: agency problems in exiting investments </li></ul></ul></ul>Forms of Financ e Agency Problems Defined Why Care About Agency Problems Summary
  10. 10. Principal  Agent (8 agency relationships here) Forms of Financ e Agency Problems Defined Why Care About Agency Problems Summary Venture Capitalist 1 Venture Capitalist 2 Entrepreneur Investors Investors Figure 2.3. Principal  Agent Relationships in Venture Capital
  11. 11. Principal  Agent (8 agency relationships here) Forms of Financ e Agency Problems Defined Why Care About Agency Problems Summary Principal Agent 1. Investor 1 Venture Capitalist 1 2. Investor 2 Venture Capitalist 2 3. Venture Capitalist 1 Entrepreneur 4. Venture Capitalist 2 Entrepreneur 5. Entrepreneur Venture Capitalist 1 6. Entrepreneur Venture Capitalist 2 7. Venture Capitalist 1 Venture Capitalist 2 8. Venture Capitalist 2 Venture Capitalist 1
  12. 12. Moral Hazard <ul><li>Effort of each party affects the expected value of the entrepreneurial venture </li></ul><ul><li>Cannot write a contract on effort (effort is observable but not verifiable) </li></ul><ul><li>Incentive to maximize effort is an increasing function of an agent’s residual claim to the entrepreneurial venture </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  13. 13. Multitask Moral Hazard <ul><li>Less likely to act in the interests of someone with whom you have contracted with when you have other better things to do! </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  14. 14. Bilateral Moral Hazard <ul><li>Principal  Agent </li></ul><ul><li>Each act as both principal and agent </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  15. 15. Adverse Selection <ul><li>Assume project qualities are distributed such that expected value from all projects is the same (same 1 st moments), but some projects are riskier than others (different 2 nd moments) </li></ul><ul><li>Offers of debt financing attracts riskier projects than offers of equity financing </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  16. 16. Figure 2.4. “Debt Attracts Nuts” Point A. Entrepreneur 3 lower expected cost of giving up equity to investor P r o b a b i l i t y Value of Entrepreneurial Firm Entrepreneur 1: “NUT” Entrepreneur 2 “ Heads I win” Entrepreneur 1 gets upside of all equity when investor has debt “ Tails you lose” Entrepreneur 1 does not bear cost; debt investor does. Entrepreneur 2 relatively smaller expected cost of giving up equity $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity
  17. 17. Adverse Selection (Continued) <ul><li>Assume project qualities are distributed such that expected value from all projects is the different (different 1 st moments), but all projects have the same 2 nd moments </li></ul><ul><li>Offers of equity financing attracts riskier projects than offers of debt financing </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  18. 18. Point A. Entrepreneur 3 lower expected cost of giving up equity to investor Point C. Entrepreneur 3 bankruptcy and permanent loss of control associated with investor debt Point A. Entrepreneur 3 lower expected cost of giving up equity to investor Point B. Entrepreneur 4 high expected cost of giving up equity to investor Value of Entrepreneurial Firm P r o b a b i l i t y Value of Entrepreneurial Firm Entrepreneur 3: “ Lemon” Entrepreneur 4 Figure 2.5. “Equity Attracts Lemons” Entrepreneur 3 Incentives to give equity to investor to help shift distribution right $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity
  19. 19. Free Riding <ul><li>Consider a syndicated venture capital investment </li></ul><ul><li>Effort of each venture capitalist is substitutable </li></ul><ul><li>Each venture capitalist has an incentive to “free ride” off the effort of the other venture capitalist </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  20. 20. Hold-up <ul><li>Consider a staged and non-syndicated venture capital investment contract </li></ul><ul><li>What happens if the venture capitalist decides s/he wants to renegotiate the terms of the contract? </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  21. 21. Trilateral Bargaining <ul><li>Consider a non-syndicated venture capital investment </li></ul><ul><li>Suppose the entrepreneur has control over the firm </li></ul><ul><li>Will the entrepreneur ever want to give up control over the firm to a third party? </li></ul><ul><li>What will the implications be for the initial venture capital investor? </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  22. 22. Window Dressing <ul><li>Consider a staged venture capital investment </li></ul><ul><li>At each performance review, what are the incentives of the entrepreneur? </li></ul><ul><li>How might this affect the optimal continuation decision and the value of the firm in the long-run? </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  23. 23. Some Agency Problems with Debt <ul><li>Risk Shifting </li></ul><ul><li>Underinvestment </li></ul><ul><li>Asset stripping </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  24. 24. Some Agency Problems with Debt <ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>Figure 2.6. Agency Problem of Underinvestment $ Value of Entrepreneurial Firm Payoff to Debt 45 o A B
  25. 25. Some Agency Problems with Debt <ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>Figure 2.7. Agency Problem of Asset Stripping $ Value of Entrepreneurial Firm Payoff to Debt 45 o A C B
  26. 26. Banks? <ul><li>Agency costs explain reluctance of banks to finance entrepreneurial firms </li></ul><ul><ul><li>Regulations inhibit the ability of banks to hold equity </li></ul></ul><ul><ul><li>Bankers typically do not have the time or skill set (?) to screen and monitor entrepreneurial loans where there is little collateral </li></ul></ul><ul><ul><li>Incentive scheme for bankers (fixed fees) different than that for venture capitalists (residual fees  encourage effort & risk-taking) </li></ul></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  27. 27. Question <ul><li>What explains the market for venture capitalists? </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  28. 28. When Should We Care About Agency Costs? <ul><li>Market Uncertainty </li></ul><ul><li>Entrepreneurial Quality Uncertainty (“Asymmetric Information”) </li></ul><ul><li>Technology  Asset Intangibility </li></ul><ul><li>Firm Development Stages </li></ul><ul><li>Amount Invested and Investment Specificity </li></ul><ul><li>Number of Firm Employees </li></ul><ul><li>Firm’s Operating Activities </li></ul><ul><li>Supply of and Demand for Venture Capital </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  29. 29. When Should We Care About Agency Costs? <ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>F I R M V A L U E Modigliani and Miller (1958) [no taxes] Miller and Modigliani (1963) [debt tax shields] Jensen and Meckling (1976) [agency costs] Optimal Capital Structure Figure 2.8 Capital Structure and Firm Value
  30. 30. When Should We Care About Agency Costs? <ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>F I R M V A L U E No agency costs and no monitoring & transactions costs Optimal Staging Frequency Figure 2.9 Staged Venture Capital Investments and Firm Value Staging Frequency No agency costs but monitoring & transactions costs
  31. 31. Summary <ul><li>Agency problems in all aspects of VC and PE investment </li></ul><ul><li>In this course we consider ways to mitigate agency problems through </li></ul><ul><ul><li>Fund structures </li></ul></ul><ul><ul><li>Contracts, Forms of finance </li></ul></ul><ul><ul><li>Staging, syndication </li></ul></ul><ul><ul><li>Exit strategies </li></ul></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>
  32. 32. Summary <ul><li>Important questions: </li></ul><ul><li>Can you eliminate or just mitigate agency problems in VC and PE finance? </li></ul><ul><li>Does mitigating one type of agency problem exacerbate another types of agency problem? </li></ul><ul><li>Forms of Financ e </li></ul><ul><li>Agency Problems Defined </li></ul><ul><li>Why Care About Agency Problems </li></ul><ul><li>Summary </li></ul>

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