Work Ethic, Employment Contracts, and Firm Value

Traditional agency theory assumes that managers are egoistic and need incentives to act in the best interests of the firm. As such, agency theory is a key determinant of firm size, capital structure, corporate governance, and firm value. However, traditional theory ignores the fact that some people are virtuous and do not need such incentives. If some employees are selfless, diligent, and have a sense of public duty, then the predictions of agency theory may be quite different. In this paper, we use a simplified principal-agent framework to show that the virtuosity of managers indeed affects the firm’s potential for growth, level of riskiness, and organizational structure. If a firm offers its managers a contract without incentives, it saves the cost of risksharing, but faces the risks of hiring egoistic agents who shirk or unskilled managers who cannot contribute to firm value. We derive the trade-offs that the firm faces when offering different employment contracts and show that these tradeoffs drive the firm’s optimal growth strategy and organizational structure. Surprisingly, we show that when the managers are more virtuous, the firm optimally chooses to invest in low-growth, low-risk projects and establishes a horizontal organizational structure. With less dedicated (egoistic) agents, the firm optimally chooses risky, high-growth projects and establishes a hierarchy in the organization. The analysis in this paper implies that corporate culture and societal norms are important drivers of firm structure and value. We would like to thank Alon Brav, Pino Lopomo, and David Robinson for helpful discussions at the inception of this project. Also providing useful comments and suggestions were Amil Dasgupta, Rich Mathews, Curtis Taylor, and seminar participants at Duke University. All remaining errors are of course the authors’ responsibility. Fuqua School of Business, Duke University, One Towerview Drive, Durham, NC 27708-0120, [email protected], (919) 619-5809. Fuqua School of Business, Duke University, One Towerview Drive, Durham, NC 27708-0120, [email protected], (919) 660-7683.