Academic journal article Journal of Business and Entrepreneurship

Moral Hazard When the Entrepreneur Seeks outside Equity

Academic journal article Journal of Business and Entrepreneurship

Moral Hazard When the Entrepreneur Seeks outside Equity

Article excerpt

ABSTRACT

The aim of this research is to measure the impact that the existence of real options has on the size of moral hazard when an entrepreneur seeks outside equity. The Lazear and Rosen (1981) model is used to compute moral hazard and the optimal percentage of free cash flows that the manager must receive as an incentive. The Myers (2000) model is also considered where the manager contributes not only labor, but also human capital that adds value to the firm. In a long-lived corporation with real options embedded, moral hazard is created by the risk aversion of the manager and the size of real options, implying that the greater the value of real options, the greater the moral hazard. This result occurs if the manager is an expert who recognizes real options before he enters the firm, or if the manager recognizes real options once he is part of the firm. One important consideration is that if the manager is risk neutral or if managerial effort does not impact the real options value, the moral hazard disappears, even when real options are present in the firm. In a new firm, where the manager is an entrepreneur who contributes intangible assets to the firm, the moral hazard depends on the value of real options and the percentage he receives of free cash flow. The greater the real options value, the greater the percentage of dividends he must receive, otherwise moral hazard increases and firm value decreases. This differs from Myers (2000), who argues that ownership share does not affect the firm value. However, the results of this paper are consistent with Jensen and Meckling (1976), who found that an optimal incentive might reduce moral hazard, and with Grenadier and Wang (2005) and Bitler, Moscowitz, and Vissing-Jorgensen (2005), who argued that optimal incentives might induce the manager to raise the firm value by exercising the appropriate real options.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Jensen and Meckling (1976) argued that it is impossible for the principal to align at zero cost the manager's interests to the principal's interests. Since Jensen and Meckling, agency theory has advanced through theoretical and empirical research on incentives because they may reduce the agency problem in the firm. This is particularly true of moral hazard because it has been related to actions after a contract is written.

Initially, the problem of moral hazard was considered only inside the firm. More recently, it was extended to principal -agent issues in the boundaries of the firm, in the interaction of the firm with the financial markets (Myers, 2000), consumer markets (Roemer, 2004), and regulatory agencies (Lafont & Martimort, 2001; Lafont & Tirole, 1993). In the boundaries of the firm, where all the factor markets are considered as principal and the firm as agent, particularly relevant is the stream analyzing the relationship between outside equity markets and the firm (Myers, 2000; Lambrecht & Myers, 2005; Jin & Myers, 2005).

Myers' (2000) work changed the way the traditional relationship between outside equity and the firm is viewed. The view has changed from one in which the manager only contributes labor in the production function, to a position in which the manager also contributes capital, in the form of human knowledge (intangible capital). However, Myers considers a world of perfect and efficient markets, under full and complete information. The labor market may not be considered efficient if the manager contributes to the production function not only with labor but also with human capital, which is intangible, very specific, and scarce, characteristics opposed to an efficient market. Full and symmetric information is not an attribute of most investment projects (especially when they have real options embedded), where the manager participates in the decision making process and retains the control rights over important strategic decisions such as deferring, expanding, contracting, abandoning, or otherwise altering investments at different stages during their operating life. …

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