This may turn out to be simply riskier debt as in case (i), or, when the Coase
problem is very serious, a combination of debt and equity as in case (ii). Note
that risky debt can always be reinterpreted as a combination of safe debt and
equity. Therefore, we can reinterpret Proposition 3 in the following way. For
any level of W, the investor holds a combination of safe debt and an equity
share s = 1 — rhψ-rl ; (i) if W < W, then safe debt is equal to RL ; (ii) if
W ≥ W , then safe debt is RL — b(R φ-R ). In both cases, the investor holds the
same kind of claim, except that the riskless component is reduced as W grows
larger: for large values of W the safe debt component becomes smaller and
the investor gets most of his return from his equity-holding. This is because
a larger entrepreneurial stake implies a more serious commitment problem for
the investor.
There is a close analogy between our financial contracting result and the
remedies for the upstream monopolist’s Coase problem envisioned by the fore-
closure doctrine. As Rey and Tirole (2000) suggest, the upstream monopolist
may want to integrate downwards with one of the downstream firms, in order
to eliminate the temptation of opportunism and credibly commit itself to re-
duce supplies to downstream firms. Equity-holding plays the role of vertical
integration in our context.
Our result provides an explanation for why equity financing is widely used
even in environments characterized by strong informational asymmetries, such
as the financing of new firms and emerging industries. Agency theory suggests
that an investor concerned by the asymmetry of information associated with
start-ups, should hold low information intensity securities, such as debt (see,
e.g. Myers-Majluf 1984). That such firms are often financed by equity issues
is therefore something of a puzzle. Existing explanations for the use of equity
have pointed to the need to reduce excessive risk-taking by the entrepreneur.
However, we argue that the use of equity in such industries can often be seen
as a response to the Coase problem. Two features of new industries make them
particularly vulnerable to the Coase problem. Firstly, successful entry into an
emerging industry is often easier than entry into a mature industry comprising
firms with established reputations, so the temptation to fund competitors is
greater. Secondly, the riskiness of start-ups means that few investors are willing
to provide capital to such firms, so investors in such industries have a degree
of monopoly power over entrepreneurs. An important class of investors in
start-ups and new industries are venture capitalists. Therefore, in section 7
we extend our model to perform a more specific analysis of the venture capital
industry.
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