JSTOR

Capital Market Discipline versus Managerial Incentive Contracts In the preceding analysis, the principal solved the agency problem by exposing the manager to external capital market discipline. Alternatively, the principal could have adopted an internal managerial incentive scheme, whereby the manager is fired if she behaves “opportunistically,” that is, does not pay out a dividend at date 1. As the manager is indispensable for running the firm, firing the manager is then equivalent to closing down the firm and liquidating assets in place. We now discuss the effectiveness of such an internal managerial incentive scheme.

The main difference between the two incentive schemes lies in the extent to which the party in control of the liquidation decision internalizes customers’ cost from liquidation. Given that creditors’ claims are senior to the warranty claims of customers, creditors do not internalize ex post the costs customers bear in the event of liquidation. The initial owner, instead, would internalize at least part of these costs. This softens his commitment to penalize the manager, which in turn undermines the manager’s payout discipline.

Indeed, consider the case where the principal is protected by limited liability. As warranty claims are senior to those of shareholders, the principal would realize a payoff of if he closed down the firm at date 1. Since , the firing threat would lack credibility: if the principal exercised the firing threat, he would realize a payoff of zero. Anticipating the principal’s lack of commitment, the manager would fully divert cash flows. This consideration would be even more pronounced if the principal were not protected by limited liability. With personal guarantees the principal would derive a strictly negative payoff if he exercised the firing threat. This underpins the key role of leverage in our setting: as creditors do not internalize the cost that liquidation imposes on customers, they are tougher vis‐à‐vis the manager, which in turn enhances her payout discipline. In this respect, external capital market discipline dominates managerial incentive contracts in our setup.

When Should Customers Pay for After‐Sales Service? We have assumed above that customers pay for after‐sales service up front. Alternatively, we could have considered that customers pay for service when it is provided, namely, during the second period. We now explore the optimality of this strategy. Suppose that the payment for service is delayed until the second period. Customers then bargain with the firm about the provision of service and the price charged for it. Customers’ outside option is to purchase service from an external provider at cost C(φ). Therefore, assuming that the firm makes a take‐it‐or‐leave‐it offer, the price charged for the service is C(φ). Customers’ willingness to pay for the product at date 0 is then given by .

To ensure comparability with the base model, let us assume that the firm also experiences a cost shock in the second period: with probability φ, the firm generates service profits C(φ), while with probability , service profits are zero. Given this assumption, if the service payment is delayed, then the firm makes expected profits and θC(φ), in the first and second period, respectively. Total expected profits thus equal θV(φ), which is precisely the amount the firm would raise if agency problems were not of concern and customers paid for service up front.

How does delaying the service payment alter the cash extraction problem? An immediate observation is that the second‐period service revenues fully accrue to the manager, since at date 2 creditors no longer have leverage over the manager. This, however, does not necessarily imply that delaying the service payment is suboptimal. The reason is that the second‐period income enhances the manager’s control benefit, which in turn improves her payout discipline after the first period. It turns out that, under certain conditions, the latter effect is irrelevant.

Proposition 3. If the cash constraint is binding in the base model, that is, , then delaying payment for service is strictly suboptimal.

Proof. See the appendix.

The key effect of delaying payment for service is that it shifts income from the first to the second period. Accordingly, if the cash constraint is already binding in the base model, then it must be strictly suboptimal to delay the service payment, as doing so only entails a further tightening of the cash constraint.16 This reduces the payment that can be extracted from the manager. It is worth noting that this reasoning would still apply if the firm did not experience a second‐period cost shock. To see this, suppose that the manager generates a second‐period service profit of C(φ) (rather than an expected profit of θC(φ)). In this context, the relevant cash constraint remains unaltered, as the firm’s first‐period income is given by , regardless of whether the firm experiences a second‐period cost shock. By implication, the principal prefers to have customers pay up front even when, in the absence of managerial incentive problems, payment for service would be delayed until the second period.

The Nature of the Cost Shock In the base model, we have assumed that the cost shock wipes out product market revenues. We now relax this assumption. Consider the case in which the firm faces a fixed cost shock of size . To make the case interesting, let us assume that F is sufficiently small, so that profits in the low cash‐flow state, denoted by Π_l, are strictly positive. In this framework, profits in the low state can be viewed as the verifiable part of income, which can be extracted from the manager at zero cost. Profits in the high cash‐flow state are then given by , where F is the nonverifiable income component.

The key difference with respect to the preceding analysis is that now part of the firm’s income can be extracted at zero cost. As a result, the principal may prefer to set the liquidation probability to zero in order to maximize the firm’s verifiable income. The following assumption ensures that the principal does not have such an incentive: The left‐hand side of this inequality can be roughly interpreted as the marginal gain from increasing the liquidation probability in the low cash‐flow state. This stems from the manager’s improved payout discipline in the high cash‐flow state and the additional liquidation proceeds in the low cash‐flow state. The right‐hand side is the marginal cost due to customers’ reduced willingness to pay. We can then state the following result (we restrict attention to interior solutions, i.e., ).

Proposition 4. Under assumption (3), the optimal debt issue with a fixed cost shock of size F entails a liquidation probability of in the low cash‐flow state (and zero in the high cash‐flow state). The proceeds of the debt issue and, hence, the principal’s payoff are given by

Proof. See the appendix.

To see the intuition behind the debt issue, notice that the liquidation probability in the low cash‐flow state is set such that the manager just has the right incentive not to divert the nonverifiable part of income in the high cash‐flow state (i.e., F). As above, the optimal degree of product differentiation maximizes the proceeds of the debt issue.

Corollary 1. The optimal degree of product differentiation φ* is characterized by where . Thus, product differentiation is decreasing in the product’s service intensity α, default risk , the inverse of the control benefit B, and the magnitude of the fixed cost shock F.

Corollary 1 shows that the results of the base model remain unchanged. The additional feature of the new setup is that product differentiation is decreasing in the magnitude of the cost shock. It is worth emphasizing that, in our model, this is not due to the likelihood of default increasing in the cost shock. Rather, the negative relation between differentiation and the magnitude of the cost shock stems from the fact that the manager has a stronger incentive to divert cash when the nonverifiable part of income (i.e., F) increases. This calls for a harsher penalty, which in turn suppresses customers’ willingness to pay. To mitigate this cost, the firm positions its product closer to those of competitors.

Managerial Wealth We have assumed that the manager has zero wealth. What if the manager had some personal wealth that she could pledge? Suppose that the manager is endowed with wealth . Let us momentarily abstract from the fact that φ is endogenous and solve for the optimal contract for a given φ. If the manager had unlimited wealth, then she would buy the firm for (and, obviously, there would be no debt issue). However, as long as the manager is wealth constrained, that is, , some debt will be issued. Moreover, it easy to see that under an optimal contract the manager transfers her wealth to the principal up front. The contracting problem amounts to subject to Clearly, as long as the manager’s wealth is sufficiently small, the participation constraint remains slack. In this case, the optimal financial structure is as in our base model. For a large w, however, the participation constraint is binding. Restricting attention to interior solutions (i.e., ), the solution to this problem is as follows.

Proposition 5. For φ given, there are wealth thresholds and such that:

Proof. See the appendix.

The key observation we wish to emphasize is that if the participation constraint is binding, then creditors’ liquidation right is decreasing in the manager’s wealth. As soon as the manager becomes financially unconstrained, the firm no longer issues any outside claims.

Consider now the choice of product differentiation. Clearly, managerial wealth has an impact on the optimal degree of differentiation only if the wealth level is between and (case b of proposition 5). As above, the optimal degree of differentiation maximizes creditors’ liquidation right—here, . Assuming interior solutions, the optimum is characterized by the first‐order condition Thus, we can state the following.

Corollary 2. As long as the manager is wealth constrained, that is, , the firm positions its product closer to those of competitors, relative to the first best. As the manager can pledge additional wealth, the firm’s product becomes more differentiated. Moreover, .

Thus, as the manager has more wealth, the firm takes a more unique approach in the marketplace. In the limit, as the manager becomes financially unconstrained, the firm’s differentiation choice converges to the unconstrained optimum .

Managerial Discretion We have assumed above that the principal chooses product differentiation and that the manager cannot alter this decision. The question is whether the manager would have an incentive to deviate from the principal’s preferred degree of differentiation if she had discretion to do so.

Proposition 6. The manager has no incentive to deviate from the principal’s preferred choice of differentiation.

Proof. See the appendix.

To see the intuition behind this result, notice that if the cash constraint is binding, then the manager pays out the firm’s entire product market income. By implication, maximizing the proceeds of the debt issue is equivalent to maximizing the firm’s product market income. This in turn implies that any deviation from the principal’s preferred choice of differentiation would drive the firm into bankruptcy even in the high cash‐flow state. The manager is then strictly worse off under the deviation, as following renegotiation the firm transfers the entire income to creditors and is liquidated with some probability (see the appendix). Conversely, if the cash constraint is not binding, then the manager is the residual claimant, and hence she has no incentive to deviate from the firm‐value‐maximizing choice of differentiation either.

This result is, of course, specific to our framework. We do believe, however, that our main qualitative insights would still apply even if there were a binding agency conflict with regard to the choice of differentiation. Notably, we conjecture that even in this case the firm would reduce the degree of uniqueness of its product in order to ease customer concerns about its viability.

Unobservable Financial Structure Our approach requires that the firm’s financial structure is observable to potential customers. If financial structure choices were unobservable, they could not possibly influence customers’ willingness to pay, and, consequently, there would be no gain to commit to a “soft” financial structure. In this situation, as we prove formally in the appendix, liquidation not only happens in the low cash‐flow state but also in high cash‐flow state. Customers’ willingness to pay for the firm’s products would be severely suppressed. This consideration suggests that firms should have an interest in voluntarily disclosing information about their financial soundness not only to influence financial market participants but also to affect customers’ willingness to pay.

Costly Differentiation Companies may refrain from adopting overly drastic product differentiation choices for reasons other than the ones considered in this article. For example, vertical product differentiation is typically associated with additional production or R&D costs. Network externalities in consumption provide another reason why a firm may not want to differentiate its product too much from rivals’ product offerings. These considerations are already captured within our setting, as the value function V(φ) has an interior maximum. Thus, the firm would face a trade‐off between too much and too little differentiation even if customers did not need to worry about the firm’s viability. The point we make is that customer concerns about firm viability accentuate this trade‐off in that they shift the balance between the costs and benefits of product differentiation toward the costs.

Cash Diversion versus Managerial Effort Moral Hazard We have used the free cash‐flow framework along the lines of Bolton and Scharfstein (1996) and Hart and Moore (1998). In this framework, managerial moral hazard arises from the noncontractibility of cash‐flow states and the potential incentive of managers to divert cash. Alternatively, we could have employed a modeling framework in which cash flows are verifiable, but the manager needs to exert noncontractible effort. The manager may then have an incentive to shirk in order to economize on private effort costs. In this context, the threat of termination can act as a disciplining device, as it does in the free cash‐flow framework (see, e.g., Aghion and Bolton 1992; Dewatripont and Tirole 1994). To the extent that liquidation is personally costly for the manager, the threat of liquidation induces her to work harder. What is needed for our qualitative insights is that following default or bad performance the party in control proceeds with liquidation, even though doing so is inefficient for all stakeholders, including customers. This could, for example, stem from a coordination failure among dispersed creditors or the inability of managers to bribe creditors not to exercise their intervention rights because of wealth constraints (see Aghion and Bolton 1992). Thus, as before, there is a trade‐off between resolving the intrafirm agency problem and easing customer concerns about the firm’s long‐term viability. This shows that the qualitative insights of our analysis do not depend on the specific agency problem under consideration.

Internal Monitoring An interesting extension of the model pertains to the possibility that the principal may resolve the agency problem by monitoring the manager. Following Diamond (1984), we posit that by expending a fixed monitoring cost K, the principal can prevent the manager from diverting cash. For example, one can think of monitoring as gathering hard evidence and making the cash‐flow state verifiable (see Gale and Hellwig 1985), so that the manager could be severely punished if she expropriated the principal. Gathering such hard evidence and bringing it to court is clearly costly for the principal; this is captured by the monitoring cost K.

In this context, the principal faces the choice between two governance mechanisms: external market discipline and internal monitoring. If the principal opts for external market discipline, then his payoff is given by (we restrict attention to interior solutions) where and φ* is characterized by equation (2). Conversely, if the principal monitors, then there is no need to impose a liquidation threat on the manager, and hence the choice of differentiation is unconstrained optimal. The principal’s payoff from monitoring is where is the first‐best degree of differentiation. Hence the following result.

Proposition 7. Suppose that the principal can resolve the agency problem by monitoring the manager at cost . Then the principal monitors if and only if that is, only if the monitoring cost is not too large, the asset salvage value is sufficiently small, default risk is sufficiently large, and the control benefit is small enough.

The proposition yields several additional empirical implications. By inspection, the principal is more “likely” to monitor if the salvage value of the firm’s assets is relatively low. This suggests that firms whose assets are not worth much when deployed elsewhere opt for monitoring‐intensive governance approaches (such as venture capital finance, relationship bank lending, or large shareholder monitoring). By contrast, firms whose assets have a high salvage value may prefer to impose external market discipline on their managers. In addition, the principal is more likely to monitor when managerial incentives are less aligned with his interests, that is, the control benefit B is relatively low. The choice between internal monitoring and external market discipline then has implications for the firm’s differentiation strategy. Firms that are monitored take a highly differentiated approach in the product market, while those adopting market discipline deliberately reduce the degree of uniqueness of their products.

It also worth noting that only relatively risky firms (θ not too large) are monitored. More specifically, notice that as θ approaches one, market discipline becomes unambiguously more cost‐efficient than monitoring. This suggests that the relation between the degree of uniqueness of a firm’s product offering and its default risk should be nonmonotonic. Relatively risky firms are monitored, which allows them to adopt a highly unique approach in the product market. This is consistent with the notion that young start‐up firms are often highly innovative. It is also consistent with empirical evidence suggesting that firms backed by active financiers who adopt “hands‐on” governance approaches, such as venture capitalists, are often more innovative than other firms (see Hellman and Puri 2000). Safer firms rationally forgo the benefits of monitoring: they find it more cost‐efficient to adopt market discipline. This, however, comes at the expense of raising customer viability concerns. Consequently, these firms position their products closer to those of competitors in an attempt to mitigate such concerns. High‐quality, established firms with very little default risk again take a highly differentiated approach in the product market.