Financial Contracting
Introduction
According to Hart, (2001), financial contracting refers to the theory where there is a compromise between the investor and the entrepreneur in matters relating to running the business. An entrepreneur can obtain capital from various sources that are: personal savings, angel, venture, private, banks, and credit unions. In this paper, the source of capital is venture capital financing which is whereby an investor provides capital to a start up entrepreneur that has no operating history. However, Ellingsen & Kristiansen, (2010), proved that financial contracts might prove disadvantageous to one party hence the need to select a specific type of financial contract that will satisfy both parties.
State-Contingent Control contract
In dealing with venture capital financing the specific financial contracting that would be beneficial to both parties is state-contingent contract. Smith, (2009) asserted that the MM (Modigliani and Miller) theory which stipulates that the methodology of financing a project does not matter was incorrect. He instead proved that aspects that would influence finance methodology were taxes, incentive problems, and decision rights (Smith, 2009). Therefore, in an organisation that is venture capitalist financed, the major issue would be in voting rights between the financers and insiders in the organisation.
Kaplan and Stromberg, (2003), observed that the control rights were restrictive and depended on the performance of a business. For instance, if the business was performing poorly, then the financer would obtain full control in decision making. The opposite is true when the company is performing well and meeting its goals. This hypothesis of allocation of voting rights is also supported by the Aghon and Bolton Model where voting rights is only important if the agreement between the entrepreneur and the financer is incomplete and if there is a conflict of interest between the two parties (Hart, 2001). In our model, the scenario that surfaces is in conflict of interest where apart from profits in monetary terms, the business would also yield certain benefits to the entrepreneur.
The quantity of profits and private benefits depend on state of nature and an interim action that is acted upon when the state of nature is realised. In the real world contracts are complete because both the state of nature and action cannot be included in an initial contract. However, the initial contract would enlist who of the two parties has the decision to choose the action at a future date. In addition, the choice of the action can be made conditional on signals that are verifiable and observable that does not correlate with state of nature.
In our case, rights of control and cash flow can be divided between the entrepreneur and the financer, but the question still remains as to who has the bargaining power. The problem can be solved by Aghion-Bolton model that has two actions, two signals, and two state-of-natures. The conclusion in this model was that under certain conditions the financer got control when the firm performed bad and in another instance the entrepreneur got control when the firm performed good (Hart, 2001). Therefore, at any one time in state-contingent contract one of the parties will have control which is more applicable when control cannot be divided. However, when control needs to be shared between the two parties, that is, when the signal is intermediate then the model needs to be altered. Therefore a model that can further be built that would favour a strong pragmatic intermediate state-contingent contract will be extending the two action, two signal and two state-of-nature model to a three action, three signal, and three state-of-nature model.
It is also noticed that in incomplete contracting which is what our business model entails, sharing of controls is not optimally done (Hart, 2001). It can further be assumed that non-optimally of joint control results when the compensation of both parties is nil in case of a conflict. The above hypothesis is seen to be more successful in seller-buyer models as opposed to financer-entrepreneur models (Hart, 2001). In the former (buyer-seller) model, contract re-negotiation occurs where both parties cannot right long term contracts. However in the case of financer-entrepreneur, long term contracts are written which include the initial financing contract.
Therefore it seems logical that entrepreneurs and financers should include guidelines that govern contract re-negotiations at the beginning. In our case, it is optimal that the entrepreneur—the contract designer—should provide guidelines of choosing the action under joint control. Thereafter the entrepreneur recommends some action which then the investor will accept or decline. When the investor accepts the action under joint control is taken while if the investor declines, then both parties would re-negotiate. If the re-negotiation does not work then both parties would gain equal control.
In conclusion, it can be stipulated that the model of Aghion and Bolton that explains control in contracts that are incomplete and when there is a conflict of interests is directly proportional with findings of Kaplan and Stromberg, (2003), who inferred that control rights in a state-contingent contract depended on a firm’s performance. Furthermore, it can also be concluded that when the size of the business is intermediate (conflict of interests is intermediately) then control allocation is optimal. Specifically, if the business is performing exceptionally well —good signal—then, the entrepreneur would always retain control while if the signal is bad—poor performance—then, the investor would gain control in decisions. Intermediate signals in this case result in joint control of both parties.
References
Ellingsen, T. & Kristiansen, E. G. (2010). Financial Contracting under Imperfect Enforcement. Journal of Financial Economics, Vol. 60- 1-44
Hart, O. (2001). Financial Contracting. Cambridge: Harvard Law School. Pp. 1-44. Downloadable at:
http://www.law.harvard.edu/programs/olin_center/
Kaplan, S., & Stromberg, P. (2003). Financial Contracting Theory Meets the Real World: An Emperical Analysis of Venture Capital Contracts. A Review of Economic Studies. Vol. 70 Issue 243, p281-315, 35p
Smith, R. (2009). Required Rates of Return and Financial Contracting for Entrepreneurial Ventures. California: University of California. Pp. 1-38
