Divestment, Entrepreneurial Incentives, and the Life Cycle of the Firm

Authors

  • Wolf Wagner

    Corresponding author
    1. The author is from Tilburg University. He thanks Michael Brennan, Riccardo Calcagno, Peter Sørensen, and seminar participants at the Stockholm School of Economics for helpful comments. This paper has benefitted substantially from the comments of an anonymous referee. (Paper received May 2007, revised version accepted October 2009)
      Address for correspondence: Wolf Wagner, European Banking Centre, TILEC, CentER and Department of Economics, Tilburg University, Postbus 90153, 5000 LE Tilburg, The Netherlands.
      e-mail: wagner@uvt.nl
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Address for correspondence: Wolf Wagner, European Banking Centre, TILEC, CentER and Department of Economics, Tilburg University, Postbus 90153, 5000 LE Tilburg, The Netherlands.
e-mail: wagner@uvt.nl

Abstract

Abstract:  An entrepreneur who wants to divest his firm suffers a time-inconsistency problem: divesting a stake creates an incentive to divest further since he does not internalize the arising agency costs for the stake already sold. This paper shows that this leads to excessive divestment in equilibrium and entails efficiency losses which can offset any potential divestment gains. As a result, firms may stay private even if there are large gains from going public. We show that venture capitalists can reduce these inefficiencies. This is because they have influence over a firm's divestment decisions and can distinguish between an excessive and a desirable dilution of equity (such as in response to liquidity shocks). We also show that the divestment inefficiency gives rise to an optimal time of going public, which trades off the gains from going public early (higher divestment gains) with its costs (higher divestment inefficiency).

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