The incomplete contracts literature emphasizes the role of ownership in providing ex ante incentives (Grossman and Hart, 1986, Hart and Moore, 1990). But ownership may be viewed as a bundle of access rights and veto rights that can provide incentives independently (Bel, 2012). A proper allocation of those rights then determines the shape of optimal governance structures that maximize the agents’ investment incentives. De-bundling ownership into access and veto reveals the emergence of intermediate control structures between entrepreneur’s ownership and investor’s ownership, such as debt and equity.
Considering the governance features of debt and equity (Williamson, 1988), we view (secured) debt as the allocation of veto rights by an entrepreneur to an investor, while equity corresponds to the allocation of access rights. In a model a la Hart and Moore (1990), we rationalize the respective roles of debt-holders and equity-holders. Debt-holders should have veto on the entrepreneur’s asset to prevent her from investing on substitutable projects; while equity-holders should have access to increase their incentives to invest. Overall, our framework highlights the distinctive roles of debt and equity, providing a rationalization of the free cash-flow theory: equity is an incentive device for investors, debt is a disciplining device for managers.
We reveal that the type of agents, the type of assets and interrelations between agents and assets determine the optimal capital and governance structures. In particular, equity financing is optimal when the entrepreneur’s asset is strongly complementary to the financial asset, whereas secured debt is optimal when the entrepreneur has low productivity and her asset is strongly substitute to external assets. When both conditions are satisfied, the investor should take full ownership. When both assets are strongly substitutes, financing by retained earnings is optimal if the entrepreneur has high productivity.
The determinants of governance and capital structure, whether firm specific or industry/economy specific, have received considerable attention from both theoretical and empirical standpoints. In our framework, the state and structure of the economy affects agents and assets, and hence plays a key role in determining the type of prevailing governance structure. For example, we find that firm profitability, R&D intensity, advertising intensity, asset differentiation should correspond to a lower leverage ratio, whereas asset tangibility, liquidity, and diversification should correspond to a higher leverage ratio. Also, the likelihood of equity financing increases with the maturity and the degree of concentration in the industry, and with the degree of technical change, whereas the likelihood of debt financing increases with the number of investment opportunities or the intensity of industry rivalry and when property rights are less secure. We confront our theoretical predictions to extant empirical studies.