Capital Structure as an Optimal Contract Between Employees and Investors



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    • Department of Finance, Carlson School of Management, University of Minnesota. I thank Gordon Alexander, Masahiko Aoki, Eli Berkovitch, Tom Chemmanur, Doug Diamond, Michael Dothan, Jim Gahlon, Ellie Harris, Milton Harris, Pat Hess, Ronen Israel, Ravi Jagannathan, Jack Kareken, Steve LeRoy, Jonathan Paul, Yingyi Qian, René Stulz, Sheridan Titman, and the seminar participants at the University of Michigan, the Stanford Economics Department and AFA for comments. I am grateful to the McKnight Foundation and to the Business Economic Research Fund for partial financial support.


The ex ante optimal contract between investors and employees is derived endogenously and is interpreted in terms of debt, equity, and employees' compensation. Although public equity financing is feasible in this model through verified accounting income, debt is needed to force value-enhancing restructuring before the income realizes. The optimal debt level, however, is lower than that which maximizes the value of the firm when there is nonmonetary restructuring-related cost to employees. The paper explains how stock prices react to exchange offers, how earnings can be diluted by a decrease in leverage, and why employees' claims are generally senior to those of investors. New testable implications about leverage and compensation levels are derived.