Entrenchment and Investment

Abstract

Corporate governance is on the reform agenda all over the globe. This paper shows that restrictions on the issuance of non-voting shares may cause managers who own equity in the firm to under-invest. When a firm issues voting shares to raise capital for new investment, there is a dilution in the manager's ownership. This increases the risk to the manager's control of the firm, decreasing his chances of obtaining the private benefits of control. The problem is most severe in firms where managers extract significant private benefits. Non-voting stock allows a firm to raise equity capital without a dilution in the manager's ownership and alleviates the under-investment problem. There are costs to the issuance of non-voting stock -- managerial entrenchment, dividend dilution and firms in the control of inferior managers. The issuance of non-voting equity is optimal when the benefits, higher firm value because of higher investment, outweigh the costs of managerial entrenchment. We obtain conditions under which it is optimal for firms to issue non-voting stock. Our theory is consistent with the empirical findings of Faccio & Masulis (2005) who show that a fear of loss of control makes shareholders reluctant to issue voting equity to finance M&A activities. In addition, our model produces new empirical predictions regarding the relationship between the likelihood of dual-class recapitalization and incumbent management quality, management ownership and the effectiveness of other mechanisms to restrict private benefits.