A little history and perspective
§ English Practice
o No default rules
§ Early U.S. Practice
o Through 1900, the vast majority of companies in the US were Railroads
§ The race to Delaware
o Race is among all the states
§ Race to the top: More shareholder protections over managers???
§ Race to the bottom: More managerial protections over shareholders.
o Delaware had the best and most efficient default rules – Maybe
§ They have the best rules as far as the managers are concerned
§ Federal v. State
o The trend most recently is to Federalize corporate law
o Most default rules are state
§ Technocratic Period (WWII – 1980’s)
§ Proprietary Period (1980’s – Now)
o The big difference between these two periods is that people are now going to jail for financial fraud
o Takeovers are now easier
o Stock options exist now where they didn’t before
o In Techno, the managers and CEO’s were trusted
Advantages of Incorporating
§ Reduces Personal Liability
§ Adds Credibility
§ Tax Advantages – Benefits deductible for you and your employees
§ Easier Access to Capital Funding
§ An Enduring Structure
§ Easier Transfer of Ownership
§ Centralized Management
Four Basic Attributes of a Corporation
§ Separate entity with perpetual existence
§ Limited Liability
§ Centralized management
§ Transferability of ownership interests
Principal v. agents (vs. debt)
§ Principal is the employer, an agent is an employee.
§ Incentives of principal (owner, shareholder)
o TO MAXIMIZE RETURN OF THE BUSINESS; maximize profit and pay a fixed claim to the employee.
o Moral hazard: Taking on add’l risk b/c of insurance, etc.
§ Incentives of agent (manager, CEO, employee)
o TO SHIRK: When the employee steals (anything you can) f/the employer.
§ Moral hazard: Taking on add’l risks in the presence of insurance.
· Eg. Driving like a maniac b/c you have insurance.
o Wants to get paid, get a portion of the company, to stay employed.
§ Maintenance of Control (p.14)
o Principle will monitor/discipline the agent to ensure he does as expected.
§ These efforts constitute agency costs.
o They should distribute the business risks to minimize conflicts and maximize the value of their participation in the venture.
o Their agreement must address:
§ the term of their relationship
§ the allocation of financial rights and obligations (profits and losses)
§ the discretion and responsibilities of the agent
§ the supervisory powers (including access to info) the principal
§ the ability of either participant to terminate their relationship
§ the means by which they can change their relationship
§ Deal points
o Risk of loss: Th
§ Market risk fluctuates w/the market.
§ Interest rate risk is just like the market risk but w/a %.
o Credit risk
§ Risk that a company or a borrower will default on a loan.
o Legal/reputational risk
§ The risk that you might do something illegal, be sued, affects your reputation.
o Expected value vs. volatility
§ Expected value: The average value that you’d expect to get f/a risky action/situation.
§ Volatility: The measure of the riskiness of the action/situation.
· Thus, you’d get paid for the risk.
§ More volatile, risky projects have higher potential value.
§ Risk neutral
o Risk neutral means you don’t care about risk
o They make decisions based solely on expected returns.
§ The “expected return” is the sum of each possible return multiplied by the probability of that return.
§ The magnitude of the risk is irrelevant in their decision-making.
§ Risk seeking
o You want the risk
o Usually so w/respect to loss.
o Takes the magnitude of risk (and expected return) into account when making a decision.