Zsuzsanna Fluck
ABSTRACT
This paper investigates the design of the control rights and the maturity
of securities when management has the ability to divert or manipulate the
cash flows, and when it is prohibitively costly for a third party, such
as court, to verify or prove any managerial wrongdoing. By endogenizing
claim structures, control rights and maturity, I derive a diverse set of
optimal contracts. Debt with a maturity shorter than the life of the assets
is sustainable when investors have the contingent right to liquidate the
firm's assets. Long-term debt can be sustained by investors' right to dismiss
management and take over the firm as a going-concern in the event of a
default. Investors are willing to hold indefinite life equity if they are
granted either the unconditional right to liquidate firm's assets or the
unconditional right to dismiss management. Finally, convertible debt can
be sustained by investors' right to dismiss management and take over the
firm in the event of default by the holder's option to convert their debt
contract to an equity contract prior to its expiration date. Consistent
with empirical evidence, this model predicts that small entrepreneurial
firms use short term bank loans, convertible debt, or outside equity at
their initial financing stage; as they show evidence of higher profitability,
they can secure longer-term financing.
Subject: Security Design (Theoretical)
Fluck: (212) 998-0341 zfluck@stern.nyu.edu
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