Financing and Corporate Growth under Repeated Moral Hazard

Financing and Corporate Growth under Repeated Moral Hazard This paper considers the impact of ̄nancial contracting on growth by exploring a model where entrepreneurs initially do R&D but subsequently need both outside investors to provide funds for capital investments and outside managers to operate the ̄rm e±ciently some time after assets are in place. The source of contracting ine±ciency is that insiders can divert cash °ows for their own bene ̄t. We employ a repeated game framework which allows us to model outside equity as well as inside equity and debt. We call our framework the two-stage model of ̄rm growth. A key ̄nding is that outside equity promotes ex post e±ciency (second stage growth) at the expense of ex ante e±ciency ( ̄rst stage growth), while debt works the opposite way. This is because equity promotes replacement of the entrepreneur, while debt promotes entrenchment. So debt has the disadvantage that it is less conducive to the implementation of second stage growth than equity, but the advantage that it provides the entrepreneur with more incentives to do R&D in the ̄rst place. Furthermore, equity is fragile, in the sense that moral hazard may be so high that investors will not ̄nance the ̄rm, regardless of the discount rate. In contrast, debt ̄nancing de ̄nitely can be raised for low discount rates. A prediction of the model is that in a cross-section of ̄rms, we should observe a preponderance of highly levered, closely-held ̄rms which have stagnated after an early growth phase.