Raghuram G. Rajan
The corporation in finance
The Journal of Finance | Volume 67, Issue 4 (Aug 2012), 1173–1217
Watch Raghu Rajan's talk

One of the cornerstones of modern corporate finance is the Modigliani-Miller Theorem, which essentially says that in a world where investors can borrow and lend as easily as corporations, the value of a firm is determined by the present discounted value of its expected cash flows, and not by how these cash flows are allocated to various claimholders—i.e., by its capital structure. One of the important assumptions of the Modigliani-Miller Theorem is the very existence of the corporation. In the largely perfect world envisioned by Miller and Modigliani, it is not clear what, if anything, determines the existence of the corporation and how it is structured. As researchers on the theory of the firm, such as Ronald Coase, Oliver Hart, and Oliver Williamson, have suggested, firms with well-defined boundaries emerge in worlds with transactions costs stemming from difficulties in contracting. But these costs are unimportant in the Modigliani-Miller world. So the Modigliani-Miller Theorem postulates the irrelevance of corporate capital structure in a world where corporations are also irrelevant in the first place. Put differently, could the imperfections that lead to the firm being organized in a particular way also lead to implications for its capital structure, and vice versa? That is indeed what I argue in this paper.

First—create a unique product

The firm's structure and its financing center around a common problem: how to create net present value—that is, value net of the opportunity costs of the inputs—and then how to allocate this back to agents in the economy in a way that maximizes value creation. I argue that the typical innovative firm undergoes two important transformations over its early life: the first transformation entails differentiation. An entrepreneur cannot create net present value simply by mimicking others unless she happens to be extraordinarily lucky or the market extraordinarily uncompetitive—very few of the myriad laundry shops or small restaurants that open (and close) every day repay anything more than the normal expected returns for the factors that are employed. To create net present value, the entrepreneur has to go out on a limb, distinguishing herself from the rest of the herd of potential competitors, and thus potentially earning sustainable profits. Thus, the process of creating positive net present value invariably implies differentiation—whether in creating new products or product varieties that nobody else manufactures, in developing production methods that are more efficient than that of the competition, or in targeting customer populations or needs that have hitherto been overlooked.

...then hire employees who take orders

However, the entrepreneur faces a critical challenge. She needs to persuade others to join her in enterprise-building activities. This is hard if the entrepreneurial venture is a significant departure from the ordinary, and is therefore both risky as well as uncertain (in the Knightian sense of entailing unknown unknowns). Clearly, one option would be to contract to buy inputs and hire services in the spot market. The entrepreneur would then be a contractor who sets up a nexus of contracts with other independent contractors—collaborators who have full independence of actions, as well as full ownership of the critical assets they use, bound only by the need to make contracted deliveries at the stipulated time. This is typically the way undifferentiated products are put together. But differentiated products often require producers to acquire special skills that have little outside market value, place facilities in locations where there are few other uses, and put together machinery in new ways that make them not just hard to sell but also hard to replace. Independent contractors may worry about the likely decline in the outside value of their human capital and their assets if they tie their fates to the venture, even as they also doubt the chances of the proposed venture. When contracts are incomplete, the entrepreneur will find it hard to ensure through contracts alone that independent contractors coordinate and specialize to the desired extent.

An example may be useful to explain this further. It is well known that car manufacturer Henry Ford perfected progressive assembly or more colloquially, the moving assembly line, whereby men stayed put and the parts and work flowed wherever they were needed. But Ford also implemented a second innovation that was key to the success of the first, the “American-system” production of parts—that is the production of parts finished to such high tolerances that they were for all practical purposes interchangeable. With it, the assembly line no longer needed artisans who could rework poorly finished parts; it could manage with moderately skilled workers. Moreover, the assembly line was not subject to delays as parts were re-jigged to fit each car. So the high tolerance of parts was essential to the low cost and high efficiency of the assembly line. But since no other car manufacturer required such high tolerances, and since Ford in his early years was known for his failures rather than his successes, it would have been hard for him to persuade suppliers to produce the tolerances he needed.

Indeed, it is far more attractive for the skeptical independent contractor to stay closer to the mainstream and provide a more conventional intermediate product that will have a market if the entrepreneur fails; the contractor's downside is protected by the deep market for the conventional intermediate product; he can obtain scale economies by producing for that larger market; he can also get more of the surplus generated by the entrepreneur if she is successful, because he retains a credible outside option. Matters are even worse in the “Prisoner's Dilemma” situation where no independent contractor wants to specialize to the business of the entrepreneur if they believe other key contractors will not specialize. Moreover, even when the independent contractor is convinced that the entrepreneur's venture will work, he can maneuver to grab a greater share of the prospective surplus instead of working to enhance it. More generally, if the venture shows initial signs of success, the presence of multiple irreplaceable independent contractors who will each up their demands as the entrepreneur tries to get them to continue, will greatly diminish the rewards to entrepreneurship, and potentially reduce the life of the enterprise. So how does the entrepreneur gain enough control to shape the transformation?

The key is for the entrepreneur to have employees, who typically have fewer degrees of freedom than independent contractors. Employees, unlike independent contractors, usually do not own the assets they work with—instead, someone else owns the irreplaceable assets that are key to the enterprise, i.e., control over their use is largely delegated to the entrepreneur. The ability to allow (or deny) access to the assets, both initially and over time, is central to the entrepreneur's ability to encourage coordination.

Standards make employees replaceable which makes financing feasible

But a differentiated unique enterprise is hard for outsiders to finance. The entrepreneur needs financing to assemble the critical assets the enterprise needs, with the problem being particularly acute if the scale at which she needs to start is large. But the financier needs to be assured of an adequate return. If the differentiated enterprise succeeds, the entrepreneur and the employees will appropriate much of the going-concern value because their irreplaceable human capital will give them bargaining power. A debt contract, whereby the creditor can lay claim to the firm's assets in case it does not make contracted payments, gives the creditor the ability to force repayment if the redeployment value of the assets or the break-up value is high. But this will typically not be the case in the differentiated firm; critical irreplaceable assets will either be intrinsically special or will have been specialized during the first transformation, which reduces alternative uses. The more the collaborator coordinates, the lower the value of the redeployment option. Moreover, the financier has to share some of the redeployment surplus with the collaborator, diminishing his own recovery in redeployment.

This is why the firm needs a second transformation, standardization, whereby the firm's operations are standardized so as to make the firm's key human capital more replaceable and liquid, even while it continues to produce the differentiated product or service. Finance requires successful start-ups to grow up and standardize what they do well, and the entrepreneur has an incentive to make this happen precisely because the firm will be run by others over time. In this way, outsiders obtain more control over the going concern, and value can be committed to them to repay their earlier financing. Equity by venture capitalists seems the natural claim with which to finance when the entrepreneur's intent is to commit to share future going concern value, since it supports payouts with the threat of replacing management even while maintaining the firm as a going concern. Equity markets play an important role by rewarding the entrepreneur for standardizing the firm, and thus providing powerful incentives for the second transformation.

First equity, then debt

The preceding might suggest that equity is always the preferred financing instrument. This is probably true only when the firm is being standardized. Once the firm is standardized, the split of surplus between equity and management is determined. If standardization is not high, equity gets only a moderate fraction of the surplus generated by an investment. If this investment is financed with an equity issuance, it is possible that old equity is “diluted” by issuance, because the share of additional surplus going to equity is outweighed by the significantly larger number of shareholders post-issue. All this then suggests a life cycle of firm financing, with firms financing with equity early on so as to enhance incentives for standardization, and financing later with debt so as to avoid diluting equity.

It is useful to lay out in Figure 1 the array of possibilities for firms and financing when we consider both standardization and differentiation. A laundry shop is low on both differentiation and standardization. A utility is low on differentiation but high on standardization, hence it is easy to finance. A wealthy family enterprise can be high on differentiation and relatively low on standardization—it can differentiate more (though families may be undiversified and risk averse, which will eventually limit differentiation) without standardizing because it has little need to cater to financial markets. Finally, a mature firm with entrepreneurial roots, such as Microsoft, scores high on both differentiation and standardization. The central forces governing the structure of the laundry shop or the small grocer are different from those governing the entrepreneurial high technology firm, and a tremendous source of confusion in the literature has been to try and understand the latter by examining the former.

1: Differentiation and standardization
Low Standardization High Standardization
Low Differentiation Laundry Shop Utility
High Differentiation Family Firm High-Tech IPO

Main Street and Wall Street must intersect

Because the cycle of up front financing followed by the two transformations is hard to commit to, path-breaking innovation, enterprise creation, and the generation of positive NPV, are all difficult. The availability of finance does alter the nature of firms that are created and explains why corporate finance is so central to innovation, firm growth, and economic development. Of course, mature firms are more capable of financing projects themselves, but the standardization many of them have undertaken to repay past finance typically renders them less capable of innovation. Analyzing the firm and its financing in this way gives us insights into who should own the firm, what the form of financing should be, and what kinds of innovation and enterprises are possible when the financial system is underdeveloped. In my presidential address, I discuss evidence that is consistent with the implications of my model.

It is tempting to succumb to the rhetoric that financial innovation and creativity are simply ways for the clever to part the innocent of their money. Such rhetoric does get louder after a crisis, and makes it easier for governments to suppress finance. What I have tried to show in my paper is that there is a very real potential cost if financiers are unable to play midwife to innovative new firms, and if equity markets are not vibrant enough to reward entrepreneurial activity. The broader point is that attempts to separate Main Street from Wall Street, real activity from “merely” finance, are not useful. The two are intimately linked, both in theory and in practice.

Gu Kaizi: Admonitions of the Court Instructress. China, 5th Century, Jing Dynasty.. This is one of the three surviving scenes from an ancient Chinese scroll that originally contained twelve scenes. Gu Kaizi was a celebrated Chinese artist who wrote three books on paintings that are still surviving. This piece is such a significant part of the early history of Chinese paintings that a copy with all twelve scenes was made in the twelfth century and now resides in the Palace Museum in Beijing. This piece passed through the hands of many collectors (including Emperors). It was finally acquired by a British officer in India during the Boxer rebellion. It was later sold to the British Museum, where it resides to this day.

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