Agency Problem and Ownership Structure: Outside Blockholder as a Signal

Abstract

We propose a model in which an entrepreneur, seeking outside financing, sells a large equity share to an outside blockholder in order to signal his low propensity to extract private benefits. A conventional theoretical rationale for the presence of an outside blockholder is mitigation of the agency problem via some type of monitoring or intervention. Our model provides a novel insight: outside blockholders may be attracted by firms with low, rather than high, agency problems. Our result yields a new implication for the interpretation of an often documented positive relationship between outside ownership concentration in a firm and its market valuation: such relationship may be driven by sorting rather than by a direct effect of blockholder monitoring. In fact, we show that the positive correlation may arise even if the blockholder derives private benefits and has no positive impact on the value of small shares. Finally, we argue that our analysis may help explain why the market reacts more favorably to private placements of equity as opposed to public issues.