A Theory of Firm Decline

Abstract

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.

Lifecycle of Enterprises and its Dynamics: Using Fractal Analogy Model in Empirical Study of Czech and Slovak Enterprises

“…The lifecycle is related to management control (Granlund, 2005 andSilvola, 2008), compared with performance measurement (Garengo, 2007 andVosloban, 2012), productivity (Halkos, 2007 andHyytinen, 2012) and for example also franchise relations (Blut, 2011). Firm star-up lifecycle progression describes McAdam (2008), growth later is analyzed by Nichter (2010), high-growth by Delmar (2003), threshold periods by Palmer (2005) and theory of firm decline is contributed by Clementi (2010). To the modeling and simulation of corporate lifecycle dedicates Hu (2007) and Ayres (2002) addresses theme of ecology and economical effectiveness with the relation to lifecycle.…”

Repeated moral hazard and recursive Lagrangeans

“…This Pareto-Negishi weight 2 becomes the new state variable 1 Many contributions have focused on the case in which agent's consumption is observable (see for example Rogerson (1985b), Spear and Srivastava (1987), Thomas and Worrall (1990), Phelan and Townsend (1991), Fernandes and Phelan (2000)) and more recently on the case in which agents can secretly save and borrow (Abraham and Pavoni (2008)); other works have explored what happens in presence of more than one agent (see e.g. Zhao (2007) and Friedman (1998)), while few researchers have extended the setup to production economies with capital (Clementi, Cooley, and Giannatale (2010)). Among applications, a non-exhaustive list includes unemployment insurance (Hopenhayn and Nicolini (1997), Shimer and Werning (2008), Pavoni (2007), Pavoni (2009)), executive compensation (Clementi, Cooley, and Giannatale (2010), Clementi, Cooley, and Wang (2006), Atkeson and Cole (2005)), entrepreneurship Quadrini (2004), Paulson, Townsend, and Karaivanov (2006)), credit markets (Lehnert, Ligon, and Townsend (1999)), and many more.…”

“…Zhao (2007) and Friedman (1998)), while few researchers have extended the setup to production economies with capital (Clementi, Cooley, and Giannatale (2010)). Among applications, a non-exhaustive list includes unemployment insurance (Hopenhayn and Nicolini (1997), Shimer and Werning (2008), Pavoni (2007), Pavoni (2009)), executive compensation (Clementi, Cooley, and Giannatale (2010), Clementi, Cooley, and Wang (2006), Atkeson and Cole (2005)), entrepreneurship Quadrini (2004), Paulson, Townsend, and Karaivanov (2006)), credit markets (Lehnert, Ligon, and Townsend (1999)), and many more.…”

Investment and Bilateral Insurance

“…3 See also Green (1987), Spear and Srivastava (1987), Quadrini (2004), Clementi, Cooley, and Giannatale (2010), and Cole, Greenwood, and Sanchez (2012).…”