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For many companies starting off in Silicon Valley, capital is raised through a combination of debt and equity financing. However, each source of capital poses different risks and obligations, and can create tension between shareholders, corporate directors, and creditors. In this article, we will consider the ultimate costs to a company of overcoming agency problems of debt and equity.
Equity Financing
At the most basic level, financing company growth with equity requires an exchange of stock for capital. Traditionally, equity financing takes the form of either an initial public offering (“IPO”) during which common stock is sold to the public, or Venture Capital (“VC”) investors provide capital in exchange for preferred stock. Over several rounds of funding, the startup will issue preferred stock to investors with different terms, risks, and potential upsides. As opposed to debt financing, financing with equity does not require the startup to return the VC firm’s investment. As a holder of equity in the company, the VC investors will share in the upside of the company, provided the startup succeeds. As shareholders, VC investors are owed fiduciary duties by the directors of the startup. The risk of director misuse of company assets implicates the directors’ fiduciary duty of loyalty to shareholders.
Equity financing creates tension between the corporate managers and VC shareholders. According to Berle-Means thesis, the modern corporation is defined by the separation of ownership and control groups. While shareholders collectively maintain complete ownership, the directors have control without ownership, so long as they themselves are not also shareholders. Under a principal-agency relationship, one party acts as the agent, working for the benefit of the principal and subject to the control of the principal. In turn, the principal empowers the agent to make decisions on their behalf and agrees to be bound by the contract entered into by the agent. Here, the shareholders assume the role of the principal, while the corporate directors assume the role of the agent. The agent-directors work for the benefit of the principal-shareholders, and the company and its shareholders are bound to the decisions made by directors. In this principal-agent relationship, there exists a risk that the agent-directors do not act in the best interests of the shareholder, and will misuse company assets for personal benefit rather than for the benefit of shareholders. This conflict of interests of the directors is often referred to as the agency problem. Agency costs are tied to informational asymmetry: agent-directors in charge of company operations often know more about the present state of the company than shareholders. Shareholders aim to limit the directors’ capacity for opportunism at the company’s expense.
According to Jensen and Meckling, the agency problem creates monitoring expenditures, bonding expenditures, and residual loss. Monitoring expenditures are the costs incurred by the company in monitoring the activity of corporate directors. Typically, monitoring costs include regular auditing, budget restrictions, controls, and equity incentive plans. Monitoring costs limit the agent-directors’ capacity for using shareholder assets for their personal benefit because the monitoring checks would bring to light any misfeasance. Jensen and Meckling also highlight that incentive plans for directors is a monitoring cost, but for the purpose of shifting the viewpoint of directors to match those of the shareholders by offering equity to directors. For directors who are also shareholders, any misuse of assets would also negatively impact them in their capacity as shareholders.
Similar to monitoring costs, bonding expenditures are the costs associated with forming contractual guarantees by directors. Shareholders can either engage in bonding on the managers against specific misconduct, or generally limit the managers’ decision making power. Bonding the directors limits their “ability to harm the stockholder” for their own personal gain, but comes with the cost of “limiting [the directors’] ability to take full advantage of some profitable opportunities.” The agency cost of bonding on the managers results in lost opportunities.
Debt Financing
While debt can take many different forms, simply put, a debt instrument requires a debtor to make repayments to the creditor with interest over a period of time. Prior to signing, the exact terms of debt instruments are negotiable. Short-term debt instruments are called notes, while longer-term debt instruments are generally called bonds. Debt can be secured with collateral assets (bonds), but they may also be unsecured (debentures). Parties can negotiate interest rates to be either fixed or floating. A company may negotiate for a “callable” debt, allowing the company in certain situations to redeem the bond at a prior date for a redemption premium.
Unlike the fiduciary duties implicated in the principal-agent relationship between shareholders and directors, contract law drives the bond market. Consequently, all bond rights, duties, terms, and obligations must lie within the “four corners” of the bond contract, and the creditor must assure that protective provisions are contained in the debt instrument. Unlike equity, a debt instrument between a company and its creditors does not create a fiduciary duty between creditors and directors; rather, these same fiduciary duties typically require that the corporate directors favor the shareholder’s interest over those of other parties, including creditors.
Absent complications, companies are required to repay the creditor according to their negotiated arrangements. However, in the event of bankruptcy, affirmative asset separation protects shareholders from accountability for the corporation’s debts. If a corporation is unable to pay its debt, neither the shareholders nor the directors are personally liable for the corporation’s debts, in which case the creditor may be unable to recover the full principal of the loan. In a startup setting, venture debt can be used to bridge the gap before capital is raised through equity. However, issuing debt to a company without a significant operating history and income poses a substantial risk to the creditors that the startup will go under and the debt will not be repaid.
Creditors are motivated by repayment of the bond with interest. As opposed to VC investors, creditors do not share directly from the upside of the company (absent warrants or convertible debt instruments), but rather profit from the interest on the debt. As opposed to equity, raising capital with debt creates tension between the company and its creditors. Creditors run the risk that the corporate directors will make decisions in favor of the shareholders, but at the creditor’s expense. Creditors seek a stable return while shareholders and directors pursue riskier alternatives. This conflict between corporate directors and creditors is often referred to as the agency problem of debt.
The agency problem of debt is best illustrated by example. A start up company is at a crossroads: the directors must decide whether to pursue one of several different opportunities. The first opportunity offers a small return with a high probability of success, and a low probability that the company will fail. The second opportunity has a high probability of failure, but on average, the second opportunity offers far greater returns.
Even when factoring in the lower probability of success, shareholders prefer the riskier opportunity if the growth in value of the company will be, on average, greater. Moreover, the shareholder and their agent-directors are disincentivized from pursuing a safer opportunity because the smaller upside is diminished further by the requirement to repay the creditor. The smaller return from the safer opportunity may be mostly negated by the need to pay back the company debts with interest. Thus, shareholders typically prefer the option with the highest average return.
Conversely, the creditor, who does not share in the upside of the company, would prefer the startup pursue the opportunity with higher probability of success and lower return. To the creditor, the success of the company under either option will return the same amount of money (the principal plus interest), and so the creditor would prefer the corporate directors to take less risky approaches to company growth. Notably, without bargaining for such an arrangement through the debt instrument, the creditor cannot force the company directors to pursue a safer opportunity, especially where the riskier opportunity better suits the shareholders.
In summary, debt can incentivize equity holders and corporate directors to pursue riskier options with the creditor’s loan, while the creditor wants the corporate directors to pursue less risky alternatives with a higher likelihood of success and repayment. Similar to the shareholders, creditors lack controls over the corporate directors, unless specifically bargained for. Akin to the bonding cost of equity, creditors may seek to contractually limit the decision making power of directors, preventing them from pursuing riskier opportunities with higher average return.
Debt Convertibility
The tension created between the corporation and creditors can be reduced, but not eliminated, by negotiating the inclusion of a conversion feature. Convertible debt allows a creditor to convert the value of a bond into equity at a fixed conversion rate. While the rate is fixed at the creation of the bond, the option to convert does not present itself until the end of the bond’s life. The creditor may choose not to convert debt to equity, but rather may opt to collect the debt, especially where the price per share of the company is lower than the conversion rate. Although the debt may be convertible to equity, in Delaware under Simons v. Cogan, 542 A2.d 785 (1987), the convertibility feature does not create a fiduciary duty between corporate directors and creditors. In situations where the company has grown during the term of the bond, the actual price per share may be higher than the conversion price. If the creditor’s negotiated conversion price is lower than the current price per share, the conversion feature effectively allows the creditor to acquire equity at a discounted rate.
Converting debt to equity allows the creditor to share in the upside of the company. If the creditor can benefit from company growth, they may be more willing to support a startup pursuing riskier opportunities. While their equity stake may be diluted, the shareholder also benefits from conversion features because it allows the company to negotiate for a lower interest rate on the bond. The amount of value added by a conversion feature is calculable with the Black-Sholes model. For both parties, convertibility reduces the tension between creditors and the corporation, reducing, but not obviating, the need for separate contractual limits imposed on directors by creditors. With the later option to become shareholders, the creditors are incentivized to allow corporate directors to pursue riskier, higher-average-return opportunities for the shareholders.
Conclusion
The agency problems of equity and debt define the relationships between shareholders, corporate directors, and creditors. The agency costs of equity highlight the tension between shareholders and directors: concerned that the directors may misuse company assets for their personal benefit, shareholders may desire to have regular auditing of company financials and other monitoring costs. Shareholders may also engage in bonding activities, limiting the power of agent-directors to engage in misfeasance, but at the cost of loss of productive opportunities. Ultimately, agency costs aid in preventing more costly misfeasance of directors.
The agency problem of debt centers on the decision-making dynamic between the corporate directors and the creditors. While the company may want to pursue riskier opportunities to grow their business, creditors are comparatively risk averse. Negotiating a debt instrument with a conversion feature allows the creditors to share in the upside growth of the company and allows the company to negotiate from lower interest rates on the debt instrument.
*The views expressed in this article do not represent the views of Santa Clara University.