A Theory of Firm Decline

Gian Luca Clementi (), Thomas Cooley () and Sonia Di Giannatale ()
Additional contact information
Thomas Cooley: New York University and NBER, USA
Sonia Di Giannatale: Centro de Investigaci´on y Docencia Econ´omicas, M´exico

Working Paper Series from Rimini Centre for Economic Analysis

Abstract: We study the problem of an investor that buys an equity stake in an entrepreneurial venture, under the assumption that the former cannot monitor the latter’s operations. The dynamics implied by the optimal incentive scheme is rich andquite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision becomes costlier as inside equity grows. In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment. In the long run, the entrepreneur gains control of all cash–flow rights and the capital stock converges to a constant value.

Keywords: Principal–Agent; Moral Hazard; Hidden Action; Incentives; Firm Dynamics. (search for similar items in EconPapers)
JEL-codes: D82 D86 D92 G32 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec and nep-cta
Date: 2008-01, Revised 2008-01

Downloads: (external link)
http://www.rcfea.org/RePEc/pdf/wp33_08.pdf

Related works:
Working Paper: A Theory of Firm Decline (2009)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:rim:rimwps:33-08

Access Statistics for this paper

More papers in Working Paper Series from Rimini Centre for Economic Analysis
Contact information at EDIRC.
Series data maintained by Francesco Billi ().