Outside Equity


  • Stewart C. Myers

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    • MIT Sloan School of Management. This paper has benefited from comments by Franklin Allen, Zsuzsanna Fluck, Jie Gan, Denis Gromb, James Ligon, Jan Mahrt-Smith, Ernst Maug, Raghuram Rajan, David Scharfstein, René Stulz, Jeremy Stein, Vincent Warther, and the referee.


Equity financing is modeled when cash flows and asset values are not verifiable. Investors have enforceable property rights to the firm's assets, but cannot prevent insiders (managers or entrepreneurs) from capturing cash flow. Insiders must coinvest and pay in each period a dividend sufficient to ensure outside investors' participation for at least one more period. Intervention by the investors must be limited by an agreement with insiders or by costs of collective action. Basic models are extended to show why firms go public and why agency costs necessarily arise when the act of investment is not immediately verifiable.