Optimal Financial Contracting: Debt versus Outside Equity

Abstract

This article presents a theory of outside equity based on the control rights and the maturity design of equity. I show that outside equity is a tacit agreement between investors and management supported by the equity-holders' right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity. As a tacit agreement outside equity is sustainable despite management's potential for manipulating the cash flows and regardless of how costly it is for equity-holders to establish a case against managerial wrongdoing. I establish that the only outside equity that investors are willing to hold in equilibrium is that with unlimited life, the very outside equity that corporations issue. Consistent with empirical evidence, this model predicts that debt-equity ratios are higher (lower) in industries with low (high) cash flow variability. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.