Optimal Contracting, Corporate Finance, and Valuation with Inalienable Human Capital

Abstract

A risk‐averse entrepreneur with access to a profitable venture needs to raise funds from investors. She cannot indefinitely commit her human capital to the venture, which limits the firm's debt capacity, distorts investment and compensation, and constrains the entrepreneur's risk sharing. This puts dynamic liquidity and state‐contingent risk allocation at the center of corporate financial management. The firm balances mean‐variance investment efficiency and the preservation of financial slack. We show that in general the entrepreneur's net worth is overexposed to idiosyncratic risk and underexposed to systematic risk. These distortions are greater the closer the firm is to exhausting its debt capacity.

Investment under uncertainty with financial constraints

“…One important difference with the generalized q-theory of investment (with convex adjustment costs) is that the financially constrained firm issues equity only for survival and never for investment as it uses its internal savings to smooth investment, and hence cannot explain the above mentioned empirical evidence on SEOs. Bolton, Wang, and Yang (2019) use the recursive optimal contracting method to develop a dynamic liquidity and risk management model also with real investment options for a firm run by an entrepreneur with inalienable human capital.…”

Inalienable Customer Capital, Corporate Liquidity, and Stock Returns

“…In our model, firms with different ICC have different exposure to financial constraints risk as a result of variation in operating leverage arising from the compensation of key talents, rather than debt limits. Incorporating (endogenous) debt limits as in Bolton, Wang, and Yang (2019b) would strengthen the implications of our model because firms with higher ICC would endogenously face tighter borrowing constraints due to lower pledgeability of their customer capital. Third, the focus of our model is on the asset pricing implications of the ICC and financial constraints (especially corporate liquidity).…”

“…The ICC is defined following the concept of inalienable human capital proposed by Hart and Moore (1994) and Bolton, Wang, and Yang (2019b). In their models, human capital is inalienable in the sense that, as a production input, it cannot be taken away from its possessors (i.e., key talents) because of limited legal enforcement.…”

“…Therefore, the ICC is fundamentally linked to the inalienability of human capital. In a sense, our notion of inalienable human capital is weaker than that of Bolton, Wang, and Yang (2019b), which is the reason our model can allow for endogenous separation between key talents and firms in equilibrium.…”

“…The concept of the ICC is built on the notion proposed by Hart and Moore (1994) and Bolton, Wang, and Yang (2019b) that human capital is inalienable; that is, a firm's capital becomes less profitable or can be (partially) taken away by key talents when they depart, in other words, key talents cannot be replaced without cost. Unlike physical capital or other types of intangible capital, such as patents, customer capital that relies heavily on the unique contribution of current key talents can be taken away or seriously reduced with their departure because of limited legal enforceability.…”