Fall 2010 – Sawyer
ECONOMICS OF THE FIRM
Controllable risks:business risks that one or more parties to the venture might be able to influence.
Ex: amount of money spent on research, advertising and marketing approach
Non-controllable risks:risks that the parties cannot control and those controllable risks that remain after all reasonable efforts to control them have been exercised.
Ex: Weather, demand for their product, interest rates
Expected Return:the weighted average return based on the probabilities of event.
Three Levels of Risk Preference
Risk averse: prefers to make decisions that are less risky
Risk seeking: prefers to make decisions that are more risky
Risk neutral: makes decisions based solely on expected returns, and would be happy to take on risk anytime it will generate a benefit on average.
People are generally less risk averse with respect to gains, and are risk seekers with respect to losses.
SH are usu. more risk seeking bc they can diversify.
Ways to avoid bearing risk
Diversification: investing in ventures that have negatively correlated risks
Placing the burden of the risk on the person who is best able to bear it
Can be reduced by monitoring and disciplining devices that align the agent’s incentives with the interests of the principal.
Shirking:when a person does less than is optimal to control a risk.
Allocating Risk to the Owner
Steps to Monitor Employee
The owner must decide what constitutes optimal performance by the employee
The owner must determine whether the desired level of performance is occurring or has occurred.
Employment contract between the employer and employee: specifies employee duties and sanctions if the employee failed to perform those duties
Allocating Risk to the Employee
Tenancy:renting the vineyard to the employee for fixed rent and allowing the employee to retain all the vineyard profits
Performance-based compensation:basing the employee’s compensation on the success or failure of the business
Annual salary of X, but if the annual net income of the business is less than Y, the annual salary will be reduced by Z%
Mixed salary and commission payment
Differing interests:short-term employee interests vs. long-term employer interests
Middle Ground Solution
Employer and employee agree to divide the profits of the business in a mutually agreeable proportion
As the employee’s returns become increasingly dependent on the success of the business, the employee will become come concerned about control
Deciding the appropriate allocation of profits is difficult
Ernest and Julia want to open a vineyard. E will be the employee. He has equipment and expertise. J is the owner of the vineyard and only knows that growing grapes is risky. Should they structure their relationship as a tenancy or as employment?
To determine which is better, we must consider who can best manage the risk.
Weather – No one, non-controllable risk
Seeds – E, controllable risk
Market forces – No one, non-controllable risk
Farming – E
Considering from E’s perspective
E would like employment bc it is lower risk – he gets paid no matter what. But that means the return is also lower, and that means lower incentives.
Considering from J’s perspective
Her risks are higher, so her return and incentives are higher.
But she doesn’t have the expertise. So how would she deal with this?
Hire a supervisor
None of these monitoring options are free.
Considering from J’s perspective
Her risk is lower. Her return and incentives are lower.
J doesn’t have to monitor
Considering from E’s perspective
His risk would be higher. His return and incentive are higher. But he has the expertise.
His monitoring costs are lower than J’s.
Solution:Tenancy is the optimal option because it leads to higher net returns. But if E is risk averse, then he would still want employment.
Understand the conflicts between SH and those who run the corp.
SH are usu. less risk averse bc they can diversify. But they are concerned about low incentives for employees.
E is like someone running the corp.
INTRODUCTION TO CORPORATE LAW
Characteristics of a Corporation
Separate Entity:Every corp. is a legal entity that is separate from the investors who provide it with money and the people who manage its business.
Perpetual Existence:A corp. has an unlimited life.
Limited Liability:A SH’s liability is limited to the amount of money she paid for her shares. It is the corp., not the SH, that own assets of the business and is liable for its debts.
Centralized Management:SH elect a corp.’s directors, who have the power to manage and oversee the corp.’s business. Directors delegate responsibility for daily decisions to corp. officers. The separation between ownership and managerial control is one of the distinctive features of the modern corp.
Transferability of Ownership Interests:SH are free to transfer their stock without obtaining the consent of other SH.
Basic Terms and Concepts
Types of Corporations
Close corporation:usu. no market for the corp.’s securities and there is a substantial overlap of ownership and management.
Public corporation:there is an available market where the corp.’s securities can be bought and sold and there is a separation of ownership and control.
Shareholders:own stock in the corp. and elect the directors.
Directors:responsible for managing the corp.’s business and elect the officers.
Officers:responsible for running the corp.’s day-to-day business.
Stakeholders:creditors, employees, customers, and the community.
Debt is more secure for those purchasing it bc debt holders get paid first.
Equity provides higher returns for those purchasing it if the corp. does well.
Of course, the flip side is also true. If the corp. sells equity and then does really well, then the corp. will keep less.
Two Fiduciary Duties
Duty of Care
Requires the director to act in the corp.’s best interests and to exercise reasonable care in overseeing the corp.’s affairs and in making business decisions.
BJR applies to duty of care. It creates a presumption that in making a business decision, the directors of a corp. acted on an informed basis, in good faith, and in the honest belief that the action was taken in the best interest of the corp.
To rebut the presumption of the BJR,a P must show that a decision either:
was not informed;
did not have a rational business purpose (i.e. constituted a waste of corp. assets);
was made by a director or directors with a personal interest in the decision; or
was made by a director or directors who otherwise were not independent (i.e. were beholden to someone who had a personal interest in the decision)
If the P is able to rebut the presumption of the BJR, the burden shifts to the directors who must prove that th
ion gets the benefit of the BJR.
TAKEAWAY:If you give to a real charity a relatively small amount then it is almost always allowed.
THE CHOICE OF ORGANIZATIONAL FORM
GP – Equal
LP – No control
Member – Equal
Manager – Equal
GP – Equal
LP – No mgmt
Member – Memb.
Manager – Man.
GP – No
LP – Yes
Equal by contribution
Corp. is taxed
Ind. are taxed
A Few Thoughts
The rules we talked about are default rules. But tax and liability rules are not default rules.
It is always better to use the form that is closest to what your client needs bc the less changes you make the safer your document will be and the cheaper it will be for your client.
Under LLC virtually everything can be changed by contract [Uniform Limited Liability Co. Act § 103], but you have to draft a lot to make it look like a corp. and it’s not easy to know how a ct. would rule on it.
Legal entity distinct from its owners
Governed by the laws of the state in which it was incorporated
Management is centralized in a BOD
Limited liability for SH, Directors, and Officers
General Partnership (GP)
All partners have unlimited liability
All partners have an equal voice in management
All partners have the authority to act as agents for the partnership and incur obligations that will bind all partners
Limited Partnership (LP)
Combines elements of a GP and a corp.
Must have at least one general partner in addition to the limited partners
General partners have comparable liability to the liability they have in a general partnership, but a limited partner’s liability is limited to the capital she has contributed to the corp.
A limited partner has no voice in the active management of the partnership, which is conducted by the general partner
Limited Liability Co. (LLC)
A legal entity distinct from its owners (called members)
Like a corp., members have limited liability