Debt as a Bonding Mechanism: Evidence from the Relations Between Employee Productivity, Capital Structure, and Outside Employment Opportunities

We investigate the disciplining role of debt in the publicly held firm by examining the relation between employee productivity and financial leverage. The unique feature of our study is that we incorporate outside employment opportunities for employees into the analysis. Consistent with the notion that the debt serves as a bonding mechanism because agents exert additional effort to avoid the personal costs of financial distress, we find a positive concave relation between employee productivity and financial leverage; employee productivity initially increases with debt and ultimately decreases. This relation is robust to controls for endogeneity and alternate measures of productivity. We also find that as outside employment opportunities increase (decrease), the positive concave productivity-leverage relation becomes weaker (stronger). Our results suggest that employees rationally trade off the costs of leaving the firm against the expected personal costs of financial distress and the disutility of additional effort. JEL classification: G30; G32; G38