A n entrepreneur is an individual with a

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1 FEDERAL RESERVE BANK OF ST LOUIS Equity Financing of the Entepeneuial Fim Fank A Schmid A n entepeneu is an individual with a poject bluepint and limited wealth If launching the poject equies expenses that exceed the entepeneu s initial wealth, he needs outside financing Entepeneus diffe fom hied management in that they ae indispensable fo the fim s day-to-day opeations This is because entepeneus add value to companies pepetually, athe than by handing ove the poject bluepints Outside financing is faught with the poblem of asymmetic infomation between the entepeneu (who is a fim inside) and the (outside) investo Asymmetic infomation between management and investo is consideed the most significant poblem in copoate finance 1 Typically, the poblem of asymmetic infomation is modeled in finance liteatue as one that petains to the use of fee cash flow by management o to management s poject choice 2 Asymmetic infomation about the use of fee cash flow can take on a vaiety of foms Fist, cash flow might be unobsevable In this case, the divesion of fee cash flow fo pesonal use by management goes unnoticed by the investo If cash flows ae unobsevable, the outside equity holde has no bagaining powe ove the allocation of fee cash flow to dividend payments Second, management s use of fee cash flow might be obsevable, but not veifiable This is when the outside can obseve management diecting fee cash flow to its own benefit, but cannot veify these actions in cout Thid, management s actions might be obsevable and veifiable, but compliance might not be enfoceable Examples of non-enfoceability ae cases whee it is pohibitively costly fo investos to go to cout, o whee cout ulings ae endeed wothless because the culpit is subject to limited liability o has limited wealth 3 In spite of the poblems of asymmetic infomation outlined above, outside equity financing of the entepeneuial fim has achieved a apid incease ove the past decade (see Figue 1) Ventue capital funds, which finance pivately held stat-ups, aised Fank A Schmid is a senio economist at the Fedeal Reseve Bank of St Louis William Bock and Judith Hazen povided eseach assistance Figue 1 Ventue Capital Raised and Nasdaq IPOs Billions $ Nasdaq IPOs a ecod $923 billion in 2000 This is a thity-fold incease elative to 1990 At Nasdaq, initial public offeings aised an all-time high of $536 billion in 2000, which is 24 times as much as in 1990 This aticle analyzes equity financing of the entepeneuial fim against the backgound of obsevable but non-veifiable cash flow The study coves thee oganizational foms: the limited patneship, the pivate copoation, and the public copoation The legal type of the fim detemines the outside equity financing options that ae available to the entepeneu By definition, initial public offeings ae available to the (hencefoth) public copoation only, wheeas ventue capital is possible fo both the limited patneship and the pivately held copoation The analysis shows that ventue capital financing is supeio to public offeings when the entepeneu has low initial wealth elative to the size of the poject and is equivalent othewise This esult highlights the impotance of pivate equity in financing entepeneuial entepises The Gamm- Leach-Bliley Act of 1999 allows banks to expand 1 See Hat (1995), Jensen (2000), and Myes (2000) 2 See Zingales (2000) Ventue Capital NOTE: Annual obsevations; last obsevation: 2000 SOURCE: Ventue Economics & National Ventue Capital Association, < Nasdaq, < 3 Fo causes of lack of obsevability, veifiability, o enfoceability and thei consequences fo contactual aangements, see Hat (1995) o Milgom and Robets (1992) 2001, THE FEDERAL RESERVE BANK OF ST LOUIS NOVEMBER/DECEMBER

2 R EVIEW the scope of thei activities in this aena The law allows financial holding companies to povide equity financing to nonfinancial fims fo up to ten yeas In paticula, the act defines a famewok in which financial holding companies can sponso pivate equity funds that povide ventue capital to entepeneuial fims While it is not the pupose of this aticle to study the consequences of the Gamm- Leach-Bliley Act on ventue capital financing, the analysis suggests that ventue capital is a significant financing instument The Gamm-Leach-Bliley Act helps impove the supply side in the ventue capital maket by boadening the spectum of institutions that ae allowed to povide pivate equity to fims that do not (o not at this stage) seek to aise capital in an initial public offeing The following analysis uses a simple model of the entepeneuial fim as poposed by Myes (2000) While the analysis of the limited patneship daws heavily on Myes, the examination of the copoation diffes fom Myes most significantly in its simplicity and its focus on the most basic diffeences among the oganizational foms The model shows that pivate copoations face less stingent financing constaints than limited patneships o public copoations The esult emphasizes the impotance of the pivate copoation as a legal fom While the model helps explain the choice of the legal fom by the entepeneu, it cannot explain tansitions among legal foms Fo instance, the analysis offes no insights into why and when a pivate copoation might go public A BRIEF LITERATURE OVERVIEW The liteatue on financing the entepeneuial fim is divese This is because the chaacteistics that define the entepeneuial fim ae multifold Moeove, some of these chaacteistics ae not unique to the entepeneuial fim but hold fo othe companies as well In the following we biefly descibe six majo economic poblems associated with financing the entepeneuial fim that have been dealt with in finance liteatue Fist, thee is the poblem of poject choice o, synonymously, asset substitution If the entepeneu holds the equity and the outside holds the debt, the inside has an incentive to choose excessively isky pojects This is because the debt holde shaes the downside isk, but not the upside isk By inceasing poject isk, the entepeneu can shift pat of the additional isk to the debt holde The classic study in this aea is Jensen and Meckling (1976) Note that the poblem of asset substitution is not confined to the entepeneuial fim Fo instance, hied management of publicly taded fims might acquie stock o stock options in the fim as pat of its compensation package Second, thee is the poblem of pivate contol benefits Management might take pleasue in being in contol of the opeations The total value of the fim consists of its social value, which is its fai maket value, and the pivate value, which is the value of the management s contol benefits The distinction between pivate and social values is impotant when it comes to the allocation of contol ights between management and outside shaeholdes Two seminal studies in this aea ae Gossman and Hat (1988) and Hais and Raviv (1988) Fo a textbook teatment, see Hat (1995) Note that pivate contol benefits ae not confined to the entepeneu, but can apply to hied management as well Thid, thee is the poblem of manageial entenchment Manageial entenchment is not confined to the entepeneuial fim, but might hold tue fo the fim with hied management as well On one hand, the highe the faction of equity owned by management, the close the inteests of management might be aligned to the inteests of the outside shaeholdes On the othe hand, the moe voting powe management has, the moe insulated it is fom the disciplining foces of the maket fo copoate contol Entenchment allows management to employ copoate esouces fo pivate benefits, fo instance, though empie building o consumption of pequisites Mock, Schleife, and Vishny (1988) and McConnell and Sevaes (1990) povide empiical evidence fo manageial entenchment Zwiebel (1996) shows in a theoetical model how entenched management can employ dividend payments as a means of committing to paying out fee cash flow and keeping outside investos fom intevening Fouth, fee cash flow might be non-veifiable When fee cash flow is non-veifiable, the inside has the oppotunity to divet it to consumptive use, fo instance, by financing pequisites Again, this poblem is not confined to the entepeneuial fim On the othe hand, non-veifiability of cash flows is seen as a significant poblem in copoate finance and it eans consideable attention in finance liteatue One thead of liteatue analyzes the ole of debt as a way of focing management to pay out fee cash flow Hat (1995) summaizes this liteatue in 16 NOVEMBER/DECEMBER 2001

3 FEDERAL RESERVE BANK OF ST LOUIS a textbook teatment Anothe thead of liteatue looks at the ole of dividend payments as a device to discipline management by maintaining a sufficient level of debt The afoementioned pape by Zwiebel (1996) fits into this categoy Finally, a ecent pape by Myes (2000) studies the ole of dividend payments in an all-equity financed fim He shows that dividend payments can be viewed as advance compensation on the outside s equity investment The dividend payment at the end of the fiscal yea compensates the investo fo the oppotunity cost of capital that he incus in the upcoming fiscal yea Fifth, thee is the poblem of isk shaing Entepeneus typically ae isk-avese individuals who have most of thei human capital and financial wealth invested in the fim Outside equity is a means of shaing isk as it allows the entepeneu to limit his exposue to the entepise Fo details, see a ecent theoetical pape by Kiilenko (2001) Sixth, thee is the poblem of asset complimentaity In the entepeneuial fim, management owns an asset that is complimentay to the fim s opeating assets This means that the entepeneu s human capital and the opeating assets ae woth moe in combination than in isolation Complimentaity between the manageial asset and the opeating assets is an attibute that is confined to the entepeneuial fim While hied management is dispensable, the entepeneu is not Myes (2000) biefly discusses this point A SIMPLE MODEL OF THE ENTREPRENEURIAL FIRM In the following analysis, the entepeneu is defined as a peson who owns human capital that is complementay to the opeating assets of a fim (a poject ) As mentioned above, assets ae complementay if they ae moe valuable when used in combination than in isolation 4 The entepeneu can add value to the fim only by being in contol of the day-to-day opeations He is indispensable fo the opeations because of his unique inventive and manageial skills As opposed to a hied manage, the entepeneu cannot be emoved fom the fim without huting the poject s net pesent value (NPV) of continuation To keep mattes simple, we assume that emoving the entepeneu fom the fim educes the NPV of continuation to zeo o, put diffeently, lowes the going concen value to the level of the liquidation value The need fo outside financing aises fom the entepeneu s wealth constaint In tems of the model, the entepeneu s initial wealth, w, falls shot of the investment needed to stat up the fim, K, which we assume to be exogenous The amount K w needs to be financed by an (outside) investo The liquidation value of the opeating assets is obsevable, veifiable (at zeo cost), and equal to K in evey fiscal yea Because the opeating assets do not depeciate, thee is an infinite investment hoizon Thee is no uncetainty in the model The poject geneates pepetual fee cash flow equal to yt = y = (1 + ) K at the end of evey fiscal yea t(t=1,, ), whee is the maginal cost of capital (fo the entepeneu and the investo) and >0 captues the value that the entepeneu adds continually to the fim though his human capital The condition >0 implies that the poject has positive NPV at the outset (ie, the beginning of fiscal yea 1), as well as positive pesent value (PV) of continuation at the end of evey fiscal yea We assume that thee ae no (othe) positive-npv pojects becoming available to the entepeneu once the poject has been stated Thus, thee is no poductive use fo intenally geneated funds The fundamental poblem of financing the entepeneuial fim is the entepeneu s ability to divet fee cash flow By vitue of being in contol of the opeations, the entepeneu can oute fee cash flow into pesonal accounts (whee it eans at the magin) The amount of fee cash flow that the entepeneu divets in fiscal yea t is denoted z t Because all fiscal yeas ae identical, we can wite the following: zt = z fo all t, t = 1,, We assume that while cash flows ae obsevable (at zeo cost) to outside investos, they ae not veifiable (o veifiable only at pohibitively high costs) Wee the poject s cash flows veifiable (at zeo cost), the poblem of asymmetic infomation in financing the entepeneuial fim would not exist Because the entepeneu would be able to commit to dividend payments, any positive-npv poject would be financed Howeve, with cash flows being non- 4 See Hat (1995) fo details on asset complementaity and its implications fo fim oganization NOVEMBER/DECEMBER

4 R EVIEW veifiable, the entepeneu s inability to commit to futue dividends leads to undeinvestment We will show that fo sufficiently low levels of initial wealth, w, o, equivalently, sufficiently low levels of poject pofitability,, thee ae positive-npv pojects that ae not undetaken The investo can povide outside financing though debt o equity In this aticle, only equity financing is consideed 5 The fim may be oganized into a limited patneship o a copoation The copoation may be pivate o public Limited patneships and pivate copoations tend to have few equity holdes, with the entepeneu being one of them The public (taded) copoation is typically modeled in finance liteatue as a copoation with dispesed equity holdes The outside investo, in this case, is a multitude of small shaeholdes whose subjective pobabilities of being pivotal to copoate decisionmaking may be viewed as zeo Fo simplicity, we assume that, in the limited patneship and the pivate copoation, the fim outside is a single investo (o, equivalently, a goup of block holdes who act as a single investo) In the next section, the poblem of equity financing is analyzed fo the limited patneship In subsequent sections the fim is modeled as eithe a pivate o a publicly taded copoation The analysis shows that the legal fom is citical fo the degee of bagaining powe the paties have ove the fiscal yea s fee cash flow, once the paties ae invested It tuns out that this ex post bagaining powe is geatest fo the outside investo in the pivate copoation Consequently, the pivate copoation faces the least estictive outside equity constaint The Limited Patneship The limited patneship consists of a geneal patne the entepeneu and one o moe limited patnes, which ae the outside investos Fo simplicity we epesent the fim outsides by a single investo (o, equivalently, a small set of block holdes that act as a single investo) Because thee is no uncetainty in the model, the diffeence between the geneal and the limited patnes lies solely in the decision ights ove liquidation, which is the only dimension of poject choice in this model Geneally, in limited patneships the outside investo can withdaw his funds (at the end of the fiscal yea), but cannot demand liquidation of (all o pats of) the opeating assets It is immateial to the mechanics of the model whethe patial liquidation is an option o whethe the poject can be liquidated in full only If patial liquidation is possible, the peiodic fee cash flow of the poject, y, deceases by the pecentage of the liquidated assets The assumption of full liquidation, on the othe hand, would mean that any liquidation, even if in pat, educes to zeo, and with it the PV of continuation 6 The (outside) investo contibutes the faction x to the initial fixed investment, K, while the entepeneu contibutes the faction 1 x: xk= K w (1 x) K= w We define x to be the faction of equity held by the investo This faction x might be smalle than, equal to, o geate than the faction of capital supplied by the investo, x, depending on whethe the entepeneu sells the equity at a pemium, at pa, o at a discount The patneship contact specifies that dividends ae paid at the end of the fiscal yea: dt = d = y z fo all t, t = 1,, Note that the faction 1 x of the dividend payment goes to the fim inside Because all fiscal yeas ae identical, we can wite the PV of the futue dividend steam at the beginning of any fiscal yea as 7 : y z d = Investo s Continuation Constaint The (outside) investo emains invested if the NPV of doing so is non-negative In deiving this continuation constaint, we assume that the patneship contact allows the investo to withdaw his funds at the end the fiscal yea, which means that thee is no vesting peiod Upon demand, the entepeneu has to pay to the investo the cash equivalent of the faction x of the liquidation value of the opeating assets Note that if the investo withdaws his funds, the entepeneu has no incentive to pay dividends fo the espective fiscal yea The investo emains invested in the fim fo (at least) one moe 5 Hat (1995) pesents an extensive teatment of debt financing of the entepeneuial fim 6 The assumption of total liquidation has the advantage of being analogous to the assumption that a fixed amount of opeating assets, K, is needed to stat the poject 7 d d Note that t = 1 ( ) t 18 NOVEMBER/DECEMBER 2001

5 FEDERAL RESERVE BANK OF ST LOUIS fiscal yea if (and only if) the sum of this fiscal yea s dividend payment and the PV of all futue dividend payments is geate than o equal to the liquidation value This yields the following continuation constaint fo the fim outside: d d x ( d+ ) xk d+ K In equilibium, the investo s continuation constaint is satisfied at equality because the entepeneu does not pay moe in dividends than is needed to keep the outside equity capital in the fim: x K = x d d K ( + ) d = 1 + Investo s Paticipation Constaint The minimum level of dividend payments that satisfies the investo s continuation constaint need not fulfill the investo s paticipation constaint, ie, his willingness to invest in the fist place Fo instance, if the outside equity wee offeed at pa (which would imply x =x), the investo s paticipation constaint would be violated This is because, fo x =x, the investo s capital contibution, xk, exceeds the PV of the dividend steam, xd/: xk x d 1 > = xk Because the entepeneu cannot commit to dividend payments geate than what is needed to keep the outside equity capital in the fim, the investo is unwilling to finance the poject in the fist place On the othe hand, the entepeneu can induce the investo to paticipate by issuing equity at a discount Upon contibuting xk in cash, the investo eceives equity claims equal to x K, x >x Note that, technically, the entepeneu can issue equity at a discount by putting pat of his own contibution, w=(1 x)k, into equity eseves while selling the outside equity at face value The entepeneu chooses the minimum x that meets the investo s paticipation constaint: xk xd x K = = This implies x =x() and consequently: x d x d x K = (1 + ) = (1 + ) xk 1 + = By issuing equity at a discount, the entepeneu tansfes the following amount to the investo at inception of the poject: ( x x ) d = ( x [1 + ] x) d = x d = xd Technically, the entepeneu can do this by tansfeing an amount equivalent to one dividend payment, d, to the eseves The implied tansfe to the investo at the amount x d inceases the etun on the outside s investment, xk, by an amount sufficient to fulfill his paticipation constaint At the same time, the investo s continuation constaint emains satisfied at equality In the Appendix we show that, in competitive capital makets, the investo cannot do bette than beak even This implies that the investo has no incentive to enegotiate the patneship contact at the end of the fiscal yea By enegotiating the contact, the investo cannot impove his position beyond the beak-even point, which is what fulfills his paticipation constaint Entepeneu s Paticipation Constaint Because the (outside) investo beaks even, the entepeneu s paticipation constaint is equivalent to the NPV decision ule: y NPV 0 K 0 Fo y/ z/+d/ and K xk +(1 x)k, we obtain z d NPV 0 + xk (1 x) K 0 With d/ (1 x )d/+x d/, we can wite z NPV 0 + (1 x ) d + x d xk (1 x) K 0 Afte eaanging tems we obtain z (1) NPV 0 + (1 x ) d (1 x) K 0 The entepeneu s paticipation constaint states accoding to inequality (1) that the PV of the diveted fee cash flow, z/, plus the eceived dividend payment, (1 x )d/, must not be lowe than the initial cash contibution, (1 x)k Thee is anothe way to ead the entepeneu s paticipation constaint Adding and subtacting xd/ fom inequality (1) yields z NPV 0 + (1 x) d ( x x) d (1 x) K 0 NOVEMBER/DECEMBER

6 R EVIEW THE LIMITED PARTNERSHIP A NUMERICAL EXAMPLE Assume the following values fo the exogenous vaiables in the limited patneship: K = 100; w = 70; = 01; = 04 Note that the poject has positive NPV: y (1 + ) K K K = = 40 > 0 If the entepeneu invests all his initial wealth, the faction of equity povided by the outside eads K w x = 03 K Factoing in the equity discount, the outside is assigned the following faction of voting stock: x (1 + ) x = 033 Dividend payments pe fiscal yea amount to K d + = = The entepeneu divets the following amount into pivate accounts at the end of evey fiscal yea: 10 z y d = 14 = The outside equity constaint is fulfilled because the entepeneu s initial wealth exceeds the equity discount ganted the outside: w 07 = > 009 K = If (and only if) the entepeneu s initial wealth amounts to not moe than 909 pecent of the amount needed to puchase the opeating assets, the outside equity constaint is violated The investo beaks even The outside s etun equals the oppotunity cost of capital: x d = = 10 pecent x K Fo x x(), we can wite z NPV 0 + (1 x) d ( x[1 + ] x) d (1 x) K 0 Afte eaanging tems, we obtain z (2) NPV 0 + (1 x) d xd (1 x) K 0 Inequality (2) states that the PV of the diveted fee cash flow, z/, plus the dividend payment on the initial capital contibution, (1 x)d/, must not fall shot of the sum of the capital tansfe to the investo, (x x)d/ xd, and the initial capital contibution, (1 x)k Outside Equity Constaint Simila to the debt capacity constaint in debt financing, thee is an outside financing constaint fo equity The constaint emeges fom the entepeneu s limited wealth The moe constained the entepeneu is, the highe the faction of equity claims he has to gant the outside The outside equity constaint states that the faction of equity claims held by the outside, x, is limited to values less than one: x <1 Fo x x(), this inequality esults in: x< 1 With x being equal to the faction of equity injected by the outside, we obtain K w < 1 K Afte eaanging tems, the outside equity constaint eads w > K The inequality states that the faction of outside equity in total liabilities must exceed a theshold that is solely detemined by the maginal cost of (equity) capital Because this condition is independent of the pofitability of the poject,, positive-npv 20 NOVEMBER/DECEMBER 2001

7 FEDERAL RESERVE BANK OF ST LOUIS pojects will not get financed if the entepeneu s initial wealth is sufficiently low Optimal Level of Outside Equity Financing As shown, the outside equity constaint sets an uppe limit to the faction of outside equity in total equity This does not imply that the entepeneu finances the highest faction possible though outside equity In fact, the entepeneu is indiffeent between investing all his initial wealth, w, o investing any amount e, 0<e<w, that satisfies the outside equity constaint As assumed, the entepeneu and the investo face the same oppotunity cost of capital Because the investo beaks even, thee is no diffeence in the costs of capital to the entepeneu with espect to outside vesus inside equity The Copoation The copoation may be pivately held (pivate copoation) o publicly taded (public copoation) We stat out with the pivate type and maintain the assumption fom the patneship model that the fim outside is a single investo (o, equivalently, a small set of block holdes that act as a single investo) In a subsequent section, we compae this oganizational type to the public copoation, assuming that the outside is a multitude of small shaeholdes Thee ae impotant diffeences between limited patneships and copoations with egad to the outside equity holde s contol ights Fist, while in the limited patneship the investo can withdaw his funds at the end of the fiscal yea, in the copoation the investo can pull his funds only if he has command ove the majoity of votes that is necessay fo liquidation 8 This is because shaeholdes cannot sell in the aggegate, even though they can tade shaes with each othe Consequently, in the copoation, minoity investos ae locked in, which makes them vulneable to oppotunistic behavio by the entepeneu Second, unlike the limited patneship, the copoation enables the outside investo if he has command ove the necessay majoity of votes to emove the entepeneu fom the fim at the annual, end-of-fiscal-yea shaeholde meeting Note that, as in the patneship model, the optimal outcome demands the entepeneu to be in contol of the opeations Also, liquidation (in full o in pat) is geneally suboptimal because the going concen value always exceeds the liquidation value The distibution of voting ights influences the balance of powe between inside and outside when bagaining ove the fee cash flow at the end of the fiscal yea In the following we look at two cases of voting ights distibution, one in which the outside has command ove a simple majoity of votes, and one in which the entepeneu holds the majoity (We exclude the bodeline case of each paty holding 50 pecent of the votes) The outcome of this bagaining pocess detemines the dividend payments, which in tun detemines the fim s outside equity financing capacity Dividends and Allocation of Voting Rights In the case whee the investo holds the majoity of votes, the outside has the powe to emove the entepeneu fom the fim o, equivalently, liquidate the fim 9 On the othe hand, the entepeneu has the powe to efuse to contibute his human capital to the fim hencefoth Any of these two non-coopeative actions by the investo o the entepeneu would educe the PV of next fiscal yea s fee cash flow fom ( )K /() to K /(), with the faction x going to the investo and the faction 1 x going to the entepeneu Moeove, we assume that, if the entepeneu wee emoved (at the end of the fiscal yea), the entepeneu would have no incentive to pay dividends fo the cuent fiscal yea Because cash flows ae not veifiable, the entepeneu would divet all of the fiscal yea s fee cash flow into pesonal accounts befoe leaving Nevetheless, the paties have an incentive to coopeate because coopeation geneates a suplus that the paties can shae The coopeative outcome may be modeled as a Nash bagaining solution In a Nash bagaining solution, each paty is assigned the same degee of bagaining powe, and thus they shae the suplus fom coopeation evenly In fact, each paty eceives what it would eceive if the paties did not coopeate plus half the gains fom coopeation 10 The suplus fom coopeation at the end of the fiscal yea equals the PV of the entepeneu s value added in the next fiscal yea, ( K )/() In shaing the suplus evenly, the entepeneu pays out 8 We assume that thee is no supemajoity ule in place, which means that all decisions ae made with a simple majoity 9 Removing the entepeneu fom the fim would esult in a PV of continuation of zeo, which is equivalent to liquidation 10 Fo details on the Nash bagaining solution, see Dagan, Volij, and Winte (2000) Fo a textbook example of a Nash bagaining solution in a copoate finance context, see Hat (1995) NOVEMBER/DECEMBER

8 R EVIEW K /(2()) to the investo, in addition to what the investo would eceive in the noncoopeative outcome, x K /() 11 Consequently, the fim s total dividend payment equals K K (1 + ) K + = 1 + Note that the dividend payment equals the PV of the fee cash flow of the next fiscal yea This implies the following fo the amount, z, that the entepeneu divets fo pesonal use: (1 + ) K z = (1 + ) K z (1 + ) K = In the case whee the entepeneu holds the majoity of votes, the outside has no bagaining powe once he is invested Because the investo has no ex post bagaining powe, the entepeneu has no incentive to pay dividends Thus, an initial pivate equity offeing in which less than 50 pecent (plus one vote) of the shaes ae up fo sale will fail (The entepeneu would have to offe the shaes fo fee, which aises no funds) Investo s Paticipation Constaint The (outside) investo expends the amount xk at the inception of the poject and eceives a dividend payment equal to K (+2x )/(2()) Thus, the investo s paticipation constaint eads xk K ( + 2 x ) 2 (1 + ) Let δ/(δ ), δ> 1, be the pecentage discount (o pemium, if negative) at which the entepeneu issues the equity to the outside; then we can wite the investo s paticipation constaint as follows: xk K ( + 2 x [1 + δ ]) 2 (1 + ) Reaanging tems yields δ 2x The entepeneu s paticipation constaint is subject to 1>x x(δ )>1/2, which demands that the outside investo holds moe than 50 pecent of the voting stock Remembe that the entepeneu chooses the discount (pemium) such that the investo meely beaks even o, in othe wods, such that the outside s paticipation constaint is satisfied at equality Because the faction of equity held by the entepeneu, 1 x, can be zeo, thee is no uppe bound on δ ; this means that, fo any 1 x x(δ ) >1/2, thee is a value δ> 1 at which the investo beaks even We assume that the entepeneu can divet any excess amount aised in the pivate equity offeing, which is analogous to ou assumption that the entepeneu can divet fee cash flow Note that thee is a lowe bound on the equity discount: δ> 1 The faction of capital injected by the investo, x, must be positive and so must be the faction of (voting) equity that emanates fom this initial capital contibution, x Entepeneu s Paticipation Constaint The entepeneu expends the amount (1 x)k at inception of the poject, eceives peiodic dividend payments equal to (1 x ) K K +, 2 (1 + ) and can divet the amount () 2 K /() into pesonal accounts at the end of evey fiscal yea Thus, the entepeneu s paticipation constaint eads (1 + ) K (1 ) + x K K + (1 x) K 0 2 (1 + ) Substituting x(δ ) fo x yields ( + δ x 1 2 ) + As with the investo s paticipation constaint discussed in the peceding section, the entepeneu s paticipation constaint is subject to 1>x x(δ ) >1/2, which demands that the outside investo holds moe than 50 pecent of the voting stock Outside Equity Constaint The entepeneu s limited wealth imposes an outside equity constaint on the fim It is this constaint that necessitates outside equity and at the same time may impose an uppe bound on the faction of outside equity in total liabilities The outside equity constaint states that the faction of equity claims held by the outside, x, must not exceed unity: x 1 Fo x x(δ ), this inequality esults in 11 Note that this outcome fulfills the investo s continuation constaint by exceeding the oppotunity cost of capital 22 NOVEMBER/DECEMBER 2001

9 FEDERAL RESERVE BANK OF ST LOUIS 1 x δ Fom the discussion of the investo s paticipation constaint, we know that the outside beaks even, which implies the following equality fo the pecentage by which the faction of equity claims held by the outside, x, exceeds the faction of the equity capital contibuted by the outside, x: δ = 2x Inseting the ight-hand-side expession into the above inequality yields x 1 2x With x being equal to the faction of capital injected by the outside, (K w)/k, we obtain K w 2 K Afte eaanging tems, the outside equity constaint eads w 2 K Except in the case of the limited patneship, the minimum faction of initial wealth, w, in total assets, K, that the entepeneu needs to launch the poject depends not only on the oppotunity cost of capital,, but also on the poject s pofitability, Limited Patneship Vesus Pivate Copoation We use the model to explain the choice between the limited patneship and the (pivate) copoation We can show that, in the pivate copoation, the outside equity constaint is less likely to bind Fo low levels of initial wealth, the entepeneu may be unable to attact outside equity when oganizing the poject into a limited patneship The pivate copoation, on the othe hand, lends geate ex post bagaining powe to the outside, which inceases the fim s outside equity capacity Note that the model is not dynamic, which implies that it cannot explain a tansition fom the patneship to the copoation, o vice vesa Assuming competitive capital makets, the outside investo cannot do bette than beak even The entepeneu anticipates the investo s ex post bagaining powe and issues the equity at the lowest discount (o highest pemium) that fulfills the investo s paticipation constaint Thus, if the poject gets financed, the entepeneu eaps all the NPV Also, if the poject gets financed, the NPV is independent of the choice of the legal fom Consequently, the entepeneu is indiffeent about the legal fom if (and only if) this decision is inconsequential to whethe the poject gets financed The only eason why a poject of positive NPV might not get financed is the entepeneu s insufficient initial wealth, w In the limited patneship, the outside equity constaint (subject to the investo s paticipation constaint being satisfied) eads w (3) > K Inequality (3) states that the entepeneu has to finance moe than the faction w/k of the poject s initial expenses, K, though initial wealth The theshold level /(+1) is solely detemined by the oppotunity costs of capital, In the (pivate) copoation, the outside equity constaint is given by w (4) 2 K Inequality (4) demands that the atio of the entepeneu s initial wealth, w, to the initial expenses needed to launch the poject, K, must meet a theshold level that is detemined by the oppotunity cost of capital,, and the pofitability of the poject, Compaing the constaints acoss legal foms shows that the outside equity constaint is moe estictive in the limited patneship model than in the pivate copoation This is because, in the pivate copoation, the ex post bagaining powe of the investo at the end of evey fiscal yea allows him to captue in a Nash bagaining solution half the value added of the upcoming fiscal yea Fo a sufficiently pofitable poject, ie, 2, the outside equity constaint neve binds in the copoation model Remembe that the outside equity constaint in the limited patneship model is independent of the poject s pofitability Going Public We now analyze the public copoation In finance liteatue, the tem public copoation NOVEMBER/DECEMBER

10 R EVIEW THE PRIVATE CORPORATION FOUR NUMERICAL EXAMPLES We assume the same set of values fo the exogenous vaiables of the pivate copoation as we did in the numeical example fo the limited patneship: K = 100; w = 70; = 01; = 04 As established fo the limited patneship, the poject has positive NPV This is because the poject etuns exceed the oppotunity cost of capital by the facto =40 pecent As in the patneship, the outside has to contibute at least the faction x (K w)/k =03 to the fim s equity capital An impotant diffeence of the pivate copoation to the limited patneship is the constaint x (δ )x>1/2, which demands that the outside holds the majoity of votes This condition esticts the entepeneu in his choice of x (the faction of capital contibuted by the outside) and δ/(δ ) (the equity discount) Fo instance, assume that the entepeneu contibutes 1 x=07 to the fim s capital, just as in the numeical example fo the limited patneship The value of δ at which the outside beaks even would then ead δ = = 056 2x This would mean that the outside equity is issued at a discount equal to δ/(δ ) 131, o in othe wods, at a pemium of about 131 pecent At this pemium, though, the outside investo would not have command ove the majoity of votes: = x (1 + δ ) x < 2 Consequently, the entepeneu chooses to contibute a lowe faction to the fim s equity than what he is able to Fo instance, the entepeneu might contibute the faction 1 x=01 only Fo 1 x=01, the value of δ at which the outside beaks even, eads δ = = 012 2x This would mean that the outside equity is issued at a discount equal to δ/(δ ) 014, o, in othe wods, at a pemium of appoximately 14 pecent The outside would end up with x (δ ) x=79 pecent of the voting stock The dividend payment amounts to ( ) K d = = The amount that the entepeneu divets into pesonal accounts equals z y d = = 1 27 The outside investo beaks even: 9= = xk K( + 2x[ δ]) = 21 ( + ) ( [ ]) = = The outside equity constaint is fulfilled: w 03 = 2 = 009 K Because the poject is sufficiently pofitable, the outside equity constaint neve binds Fo 2 the entepeneu is able to attact outside equity without contibuting his own capital This is in shap contast to the numeical example of the limited patneship, whee the entepeneu has to contibute moe than 909 pecent of the initial capital expenditue The outside equity constaint is elevant only if the poject is not sufficiently pofitable, ie, if <2 Even in this case, the outside equity constaint is less estictive than in the limited patneship Fo instance, in the patneship the poject cannot be financed if the entepeneu s wealth, w, amounts to less than 909 In the pivate copoation, though, the entepeneu can attact outside equity fo a poject with low pofitability =01 even if his wealth is as low as w=454 The entepeneu would issue the equity at a discount of 454, ganting the outside x =100 of the voting capital 24 NOVEMBER/DECEMBER 2001

11 FEDERAL RESERVE BANK OF ST LOUIS epesents listed companies with dispesed shaeholde stuctues Dispesed shaeholdes face high costs of collective action These costs estain the bagaining powe the shaeholdes have once they ae invested We assume that if (and only if) the dividend payments fall shot of the oppotunity cost of capital, the shaeholdes emove the entepeneu fom the copoation o, equivalently, liquidate the poject Note that without this assumption, the entepeneu pays no dividends Investo s Continuation Constaint As with the pivate copoation, outside equity financing is possible only if the outside shaeholdes have command ove a majoity of votes: x >1/2 Without a majoity of votes, the investo cannot liquidate, and, consequently, the entepeneu has no incentive to pay dividends In the event of liquidation, the shaeholdes can withdaw thei faction of assets Thus, the continuation constaint eads xd x K This continuation constaint is equivalent to the continuation constaint in the patneship model Investo s Paticipation Constaint Subject to x >1/2, the (outside) investo s paticipation constaint eads xk xd x K = Except fo the condition x >1/2, this paticipation constaint is identical to the investo s paticipation constaint in the patneship model Entepeneu s Paticipation Constaint Unde the assumption of competitive capital makets, the investo beaks even, which implies that the investo s paticipation constaint is fulfilled at equality Fo the investo to beak even, the entepeneu has to issue the outside equity at a discount: x = x (1 + ) Because the investo does not do bette than beak even, the entepeneu eaps the whole (positive) NPV, which implies that the entepeneu s paticipation constaint is satisfied Equivalence of Legal Foms In summay, the public copoation model is equivalent to the patneship model when the constaint x >1/2 is added and the outside equity constaint is allowed to hold at equality: Table 1 Outside Equity Constaints Legal fom Limited patneship Pivate copoation Public copoation w K In contast to the limited patneship, the wealth of the entepeneu in the copoation may adopt a value of zeo Fo the constaint x >1/2, which demands the outside to hold the majoity of votes, we obtain the following afte eaanging tems: This constaint neve binds, because the entepeneu can choose to invest only the amount e w of his wealth The outside equity constaints of all thee legal foms ae summaized in Table 1 CONCLUSION w K w K < Outside equity constaint w > K w 2 K w > K Entepeneu s initial wealth Expenses needed to puchase the opeating assets Maginal cost of capital Poject pofitability (pecentage by which the poject etun exceeds the oppotunity cost of capital) In this aticle we analyzed outside equity financing of the entepeneuial fim when cash flows ae non-veifiable The study coveed thee legal foms: the limited patneship, the pivate copoation, and the public copoation We showed that the limited patneship and the public copoation ae equivalent with egad to the outside investo s NOVEMBER/DECEMBER

12 R EVIEW bagaining powe once he is invested Of the thee analyzed legal foms, the pivate copoation endes the most ex post bagaining powe to the outside investo Consequently, when oganizing the poject into a pivate copoation, the entepeneu faces the least estictive outside equity constaint This is because the outside investos in the pivate copoation ae block holdes whose costs of collective action ae low The block holdes have the powe to emove the entepeneu fom his post (o, equivalently, liquidate the fim) Clealy, this pesupposes that the outsides hold the majoity of votes If outside equity holds a minoity inteest in the copoation, the inside has no incentive to pay dividends and will divet all fee cash flow fo pesonal use The aticle undelines the impotance of ventue capital financing Ventue capital allows positive-npv pojects that ae oganized into pivate copoations to be financed even when the entepeneu is stongly wealth-constained Fo less wealthconstained entepeneus, the thee legal types ae equivalent If the entepeneu s wealth is sufficiently low, howeve, positive-npv pojects cannot be financed in eithe legal fom This is because of the entepeneu s inability to commit to a level of dividend payments that allows the outside investo to beak even REFERENCES Dagan, Ni; Volij, Osca and Winte, Eyal A Chaacteization of the Nash Bagaining Solution Unpublished manuscipt, Bown Univesity, Washington Univesity, and Hebew Univesity, 2000, < Gossman, Sanfod J and Hat, Olive D One Shae One Vote and the Maket fo Copoate Contol Jounal of Financial Economics, Januay/Mach 1988, 20(1/2), pp Hais, Milton and Raviv, Atu Copoate Govenance: Voting Rights and Majoity Rules Jounal of Financial Economics, Januay/Mach 1988, 20(1/2), pp Hat, Olive Fims, Contacts, and Financial Stuctue New Yok: Claendon Pess, 1995 Jensen, Michael C A Theoy of the Fim: Govenance, Residual Claims, and Oganizational Foms Cambidge, MA: Havad Univesity Pess, 2000 and Meckling, William H Theoy of the Fim: Manageial Behavio, Agency Costs, and Capital Stuctue Jounal of Financial Economics, Octobe 1976, 3(4), pp Kiilenko, Andei A Valuation and Contol in Ventue Finance Jounal of Finance, Apil 2001, 56(2), pp McConnell, John J and Sevaes, Heni Additional Evidence on Equity Owneship and Copoate Value Jounal of Financial Economics, Octobe 1990, 27(2), pp Milgom, Paul and Robets, John Economics, Oganization, and Management Englewood Cliffs, NJ: Pentice-Hall, 1992 Mock, Randall; Shleife, Andei and Vishny, Robet Management Owneship and Maket Valuation: An Empiical Analysis Jounal of Financial Economics, Januay/Mach 1988, 20(1/2), pp Myes, Stewat C Outside Equity Jounal of Finance, June 2000, 55(3), pp Zingales, Luigi In Seach of New Foundations Jounal of Finance, August 2000, 55(4), pp Zwiebel, Jeffey Dynamic Capital Stuctue Unde Manageial Entenchment Ameican Economic Review, Decembe 1996, 86(5), pp NOVEMBER/DECEMBER 2001

13 FEDERAL RESERVE BANK OF ST LOUIS Appendix Is the patneship contact enegotiation-poof, o does the investo have an incentive to demand enegotiation of the contact by theatening to withdaw his funds? If at the end of the fist fiscal yea the investo theatens to withdaw his funds, the entepeneu has the option of not making the last dividend payment and substituting (enegotiation-fee) debt fo equity by issuing an infinitely lived bond, a console The console would have a pa value equal to x K and sell fo xk The peiodic, annual inteest payment would amount to x d If the entepeneu defaults on sevicing the console, the assets tansfe to the debt holde eithe entiely (total liquidation, undetaken by the investo) o patially (patial liquidation, undetaken by the entepeneu) Because the opeating assets ae woth moe in the poject than outside, the entepeneu has an incentive to make the ageed-upon payments On the othe hand, the entepeneu's ability to substitute a console fo outside equity implies that the limited patne has no bagaining powe when tying to enegotiate the patneship contact Thus the patneship contact is enegotiationfee, which in tun implies that outside equity is equivalent to debt NOVEMBER/DECEMBER

14 R EVIEW 28 NOVEMBER/DECEMBER 2001