A Theory of Firm Decline

47 Pages Posted: 28 Aug 2010

See all articles by Gian Luca Clementi

Gian Luca Clementi

New York University - Leonard N. Stern School of Business; National Bureau of Economic Research (NBER); University of Bologna - Rimini Center for Economic Analysis (RCEA)

Thomas F. Cooley

New York University - Leonard N. Stern School of Business; National Bureau of Economic Research (NBER)

Sonia B. Di Giannatale

Centro de Investigación y Docencia Económicas (CIDE)

Multiple version iconThere are 3 versions of this paper

Date Written: July 20, 2009

Abstract

We study the problem of an investor that buys an equity stake in an entrepreneurial venture, under the assumption that the former cannot monitor the latter’s operations. The dynamics implied by the optimal incentive scheme is rich and quite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, invested capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision is costlier the wealthier the entrepreneur (the greater is inside equity). In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment.

Keywords: Principal Agent, Moral Hazard, Hidden Action, Incentives, Survival, Firm Dynamics

JEL Classification: D82, D86, D92, G32

Suggested Citation

Clementi, Gian Luca and Cooley, Thomas F. and Di Giannatale, Sonia B., A Theory of Firm Decline (July 20, 2009). FEEM Working Paper No. 88.2010. Available at SSRN: https://ssrn.com/abstract=1666817 or http://dx.doi.org/10.2139/ssrn.1666817

Gian Luca Clementi (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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University of Bologna - Rimini Center for Economic Analysis (RCEA) ( email )

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Thomas F. Cooley

New York University - Leonard N. Stern School of Business ( email )

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National Bureau of Economic Research (NBER)

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Sonia B. Di Giannatale

Centro de Investigación y Docencia Económicas (CIDE) ( email )

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Col. Lomas de Santa Fe
Mexico City, Mexico 01210
Mexico

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