A Theory of Firm Decline
We study the problem of an investor who 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.
We are grateful to Dave Backus, Heski Bar-Isaac, Alberto Bisin,Andre De Souza, Kose John, Boyan Jovanovic, Claudio Loderer, Bob Lucas, Narayana Kocherlakota and Tom Sargent, as well seminar attendants at the Minneapolis Fed, NYU, the 2008 Midwest Macro Conference in Philadelphia, the 2008 meetings of the Society for Economic Dynamics (Cambridge, MA) and European Economic Association (Milan), and the 2009 Econometric Society Meeting in Boston for their comments and suggestions. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
Gian Luca Clementi & Thomas Cooley & Soni Di Giannatale. "A Theory of Firm Decline," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics. Volume 13, Issue 4, October 2010, Pages 861-885 citation courtesy of