© cumming & johan (2013)agency problems cumming & johan (2013, chapter 2) 1
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© Cumming & Johan (2013) Agency Problems
Chapter Objectives
• Forms of finance
• Agency problems
• Differences across securities
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© Cumming & Johan (2013) Agency Problems
Forms of Finance
• Debt 1st priority in bankruptcy Stipulated interest payments Non-payment of interest can force bankruptcy
• Preferred Equity 2nd priority in bankruptcy Stipulated preferred dividend payments Non-payment of dividends cannot force bankruptcy
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Forms of Finance (Con’t)
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
• Common Equity Last priority in bankruptcy Dividends may or may not be forthcoming Residual claimants upside potential capital gains!
• Warrants Option to purchase common equity Like an American call option to purchase the firm (but different
because increases # securities when exercised)
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© Cumming & Johan (2013) Agency Problems
Forms of Finance (Con’t)
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
• Convertible debt Debt + option to convert from debt to common equity Similar to debt + warrants
• Convertible preferred equity Preferred equity + option to convert from preferred equity to
common equity Similar to preferred equity + warrants
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© Cumming & Johan (2013) Agency Problems
Figure 2.1. Payoff Functions
$
Value of Entrepreneurial Firm
Payoff to Common Equity
Payoff to Debt
Payoff toPreferred Equity
45o 45o 45o
Present Value of Interest + Principal on Debt
Present Value of Pre-Specified Preferred Dividends
Slope is 45o for 100% of the common shares(45o * X/100 for X% of the common shares)
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© Cumming & Johan (2013) Agency Problems
Figure 2.2. Payoff Function for Convertible Security
$
Value of Entrepreneurial Firm
Payoff toConvertible Security
45o
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© Cumming & Johan (2013) Agency Problems
Agency Theory
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
• High risks and informational asymmetries in venture capital finance lead to problems of: Moral Hazard Adverse Selection Free Riding Hold-up Trilateral Bargaining Window Dressing Among other problems…
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© Cumming & Johan (2013) Agency Problems
Chapter 2 theory used throughout book
• Chapter 2 forms the basis for all subsequent chapters
• Part II Chapters 4-9: agency problems in fund management
• Part III Chapters 10-14 and Part IV Chapters 15-18: agency problems in relationships with entrepreneurs
• Part V Chapters 19-22: agency problems in exiting investments
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Principal Agent (8 agency relationships here)
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
Venture Capitalist 1 Venture Capitalist 2
Entrepreneur
Investors Investors
Figure 2.3. Principal Agent Relationships in Venture Capital
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© Cumming & Johan (2013) Agency Problems
Principal Agent (8 agency relationships here)
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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
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© Cumming & Johan (2013) Agency Problems
Moral Hazard
• Effort of each party affects the expected value of the entrepreneurial venture
• Cannot write a contract on effort (effort is observable but not verifiable)
• Incentive to maximize effort is an increasing function of an agent’s residual claim to the entrepreneurial venture
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Multitask Moral Hazard
• Less likely to act in the interests of someone with whom you have contracted with when you have other better things to do!
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Bilateral Moral Hazard
• Principal Agent• Each act as both principal and agent
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Adverse Selection
• Assume project qualities are distributed such that expected value from all projects is the same (same 1st moments), but some projects are riskier than others (different 2nd moments)
• Offers of debt financing attracts riskier projects than offers of equity financing
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Probability
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 toPreferred Equity
Figure 2.4. “Debt Attracts Nuts”
Point A. Entrepreneur 3 lower expected cost of giving up equity to investor
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© Cumming & Johan (2013) Agency Problems
Adverse Selection (Continued)
• Assume project qualities are distributed such that expected value from all projects is the different (different 1st moments), but all projects have the same 2nd moments
• Offers of equity financing attracts riskier projects than offers of debt financing
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Probability
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 toPreferred Equity
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
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© Cumming & Johan (2013) Agency Problems
Free Riding
• Consider a syndicated venture capital investment
• Effort of each venture capitalist is substitutable
• Each venture capitalist has an incentive to “free ride” off the effort of the other venture capitalist
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Hold-up
• Consider a staged and non-syndicated venture capital investment contract
• What happens if the venture capitalist decides s/he wants to renegotiate the terms of the contract?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Trilateral Bargaining
• Consider a non-syndicated venture capital investment• Suppose the entrepreneur has control over the firm• Will the entrepreneur ever want to give up control over
the firm to a third party?• What will the implications be for the initial venture
capital investor?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Window Dressing
• Consider a staged venture capital investment• At each performance review, what are the incentives of
the entrepreneur?• How might this affect the optimal continuation decision
and the value of the firm in the long-run?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Some Agency Problems with Debt
• Risk Shifting
• Underinvestment
• Asset stripping
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Some Agency Problems with Debt
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
Figure 2.6. Agency Problem of Underinvestment$
Value of Entrepreneurial Firm
Payoff to Debt
45o
A
B
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© Cumming & Johan (2013) Agency Problems
Some Agency Problems with Debt
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
Figure 2.7. Agency Problem of Asset Stripping$
Value of Entrepreneurial Firm
Payoff to Debt
45o
A
C
B
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© Cumming & Johan (2013) Agency Problems
Banks?
• Agency costs explain reluctance of banks to finance entrepreneurial firms Regulations inhibit the ability of banks to hold equity Bankers typically do not have the time or skill set (?) to screen
and monitor entrepreneurial loans where there is little collateral
Incentive scheme for bankers (fixed fees) different than that for venture capitalists (residual fees encourage effort & risk-taking)
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Question
• What explains the market for venture capitalists?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
When Should We Care About Agency Costs?
• Market Uncertainty• Entrepreneurial Quality Uncertainty (“Asymmetric
Information”)• Technology Asset Intangibility• Firm Development Stages• Amount Invested and Investment Specificity• Number of Firm Employees• Firm’s Operating Activities• Supply of and Demand for Venture Capital
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
When Should We Care About Agency Costs?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
FIRMVALUE
ModiglianiandMiller (1958)[no taxes]
Miller and Modigliani (1963)[debt tax shields]
Jensen and Meckling(1976) [agency costs]
Equity Debt
Debt
Optimal CapitalStructure
Figure 2.8 Capital Structure and Firm Value
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© Cumming & Johan (2013) Agency Problems
When Should We Care About Agency Costs?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
FIRMVALUE
No agency costsand no monitoring& transactions costs
Optimal StagingFrequency
Figure 2.9 Staged Venture Capital Investments and Firm Value
Staging Frequency
No agencycosts butmonitoring &transactionscosts
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© Cumming & Johan (2013) Agency Problems
Summary
• Agency problems in all aspects of VC and PE investment
• In this course we consider ways to mitigate agency problems throughFund structuresContracts, Forms of financeStaging, syndicationExit strategies
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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© Cumming & Johan (2013) Agency Problems
Summary
• Important questions:
• Can you eliminate or just mitigate agency problems in VC and PE finance?
• Does mitigating one type of agency problem exacerbate another types of agency problem?
Forms of FinanceAgency Problems Defined
Why Care About Agency ProblemsSummary
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