Strategic delegation, stock options, and investment hold-up problems

Abstract

In vertical relationships, when a contract is incomplete, underinvestment problems can arise because a seller's sunk investment costs are ignored in ex post negotiation with a buyer. In this situation, this research examines how the seller's strategic delegation in bargaining using stock options can mitigate the investment hold-up problem in vertical relationships. Under the strategic delegation in bargaining using stock options, the investment cost is not sunk and it is a relevant cost from a manager's perspective because the sunk investment cost is now reversible depending on the manager's exercise decision of stock options. Thus, under the strategic delegation, the reversible sunk costs become relevant costs in the ex post negotiation and the relevant investment costs increase transaction price in the negotiation. The resulting increased transaction price improves the seller's profit, and the improved return on investment induces the first-best level of investment by the seller firm. Unlike previous research, the first-best level of investment can be achieved without relying on any ex ante agreement and renegotiation. The bargaining effect of stock options is robust so that the first-best result can be still obtained when an endogenous exercise price, bilateral investments, cooperative investments, and a simple moral hazard problem are considered.