Equity Participations, Hold-Up, and Firm Boundaries

Abstract

Equity participations affect the hold-up problem in two ways. On the one hand, they allow to reduce the externality that is created ex-post by hold-up. On the other hand, they change the bargaining positions by partially internalizing the threat of walking away from the bargaining. It turns out that, for firms that are run by professional managers and that bear the costs of the relevant investments, the bargaining effect is the more important. In some cases, it even allows to achieve complete efficiency. In particular, with one-sided dependency, a 50% participation gives full efficiency. In the case of bilateral dependency, the unique efficient solution is equivalent to a merger. This basis for determining optimal firm boundaries is essentially one of incentive design, as suggested by Holmstrom (1999), rather than property rights. The theory also shows how joint ventures can sometimes realize the benefits of equity participations, while avoiding some concurrent problems.

Keywords: Hold-up, Equity, Equity Participation, Incomplete Contracts, Theory of the Firm, Firm Boundaries

JEL Classification: D23, G32, G34, L14, L22