© Cumming & Johan (2013)Agency Problems Cumming & Johan (2013, Chapter 2) 1.

© Cumming & Johan (2013) Agency Problems

Agency Problems

Cumming & Johan (2013, Chapter 2)

1


Chapter Objectives

• Forms of finance

• Agency problems

• Differences across securities

2


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

3


Forms of Finance (Con’t)



• 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)

4


Forms of Finance (Con’t)



• 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

5


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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Figure 2.2. Payoff Function for Convertible Security

$


Payoff toConvertible Security

45o

7


Agency Theory



• 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…

8


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



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Principal Agent (8 agency relationships here)



Venture Capitalist 1 Venture Capitalist 2

Entrepreneur

Investors Investors

Figure 2.3. Principal Agent Relationships in Venture Capital

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Principal Agent (8 agency relationships here)



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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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



12


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!



13


Bilateral Moral Hazard

• Principal Agent• Each act as both principal and agent



14


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



15


Probability


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

$



Payoff to Debt


Figure 2.4. “Debt Attracts Nuts”

Point A. Entrepreneur 3 lower expected cost of giving up equity to investor

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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



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Probability


Entrepreneur 3: “Lemon” Entrepreneur 4

Figure 2.5. “Equity Attracts Lemons”

Entrepreneur 3 Incentives to give equity to investor to help shift distribution right

$



Payoff to Debt



Point C. Entrepreneur 3 bankruptcy and permanent loss of control associated with investor debt


Point B. Entrepreneur 4 high expected cost of giving up equity to investor


18


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



19


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?



20


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?



21


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?



22


Some Agency Problems with Debt

• Risk Shifting

• Underinvestment

• Asset stripping



23





Figure 2.6. Agency Problem of Underinvestment$


Payoff to Debt

45o

A

B

24





Figure 2.7. Agency Problem of Asset Stripping$


Payoff to Debt

45o

A

C

B

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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)



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Question

• What explains the market for venture capitalists?



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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



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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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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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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



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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?



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© Cumming & Johan (2013)Agency Problems Cumming & Johan (2013, Chapter 2) 1.

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Transcript of © Cumming & Johan (2013)Agency Problems Cumming & Johan (2013, Chapter 2) 1.