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Independent Directors and Board Control in Venture Finance

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  • Broughman, Brian
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    Abstract

    The financial contracting literature treats control as an indivisible right held either by a firm’s entrepreneurs or by its investors. In contrast, data from VC-backed firms shows that board control is typically shared, with a third-party independent director holding the tie-breaking board seat (‘ID-arbitration’). In this article I use a bargaining game similar to final offer arbitration to model a firm’s choice of action under ID-arbitration. I show that ID-arbitration can reduce holdup by moderating each party’s ex post threat position. Consequently, ID-arbitration can lead to the efficient outcome in circumstances where alternative governance arrangements – entrepreneur control, investor control, or state-contingent control – are either unavailable or likely to lead to suboptimal results. This project has implications for the literature on financial contracting and the theory of the firm.

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    Bibliographic Info

    Paper provided by Berkeley Olin Program in Law & Economics in its series Berkeley Olin Program in Law & Economics, Working Paper Series with number qt9w966114.

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    Date of creation: 01 May 2008
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    Handle: RePEc:cdl:oplwec:qt9w966114

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    Keywords: G24; G32; G34. K12; K22; M13;

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    1. Hermalin, Benjamin E & Weisbach, Michael S, 1998. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," American Economic Review, American Economic Association, vol. 88(1), pages 96-118, March.
    2. Hellmann, Thomas F., 2002. "IPOs, Acquisitions and the Use of Convertible Securities in Venture Capital," Research Papers 1702r, Stanford University, Graduate School of Business.
    3. Crawford, Vincent P, 1979. "On Compulsory-Arbitration Schemes," Journal of Political Economy, University of Chicago Press, vol. 87(1), pages 131-59, February.
    4. Benjamin E. Hermalin & Michael S. Weisbach, 2003. "Boards of directors as an endogenously determined institution: a survey of the economic literature," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 7-26.
    5. Kaplan, Steven & Strömberg, Per Johan, 2000. "Financial Contracting Theory Meets The Real World: An Empirical Analysis Of Venture Capital Contracts," CEPR Discussion Papers 2421, C.E.P.R. Discussion Papers.
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    7. Oliver Hart, 2001. "Financial Contracting," Journal of Economic Literature, American Economic Association, vol. 39(4), pages 1079-1100, December.
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    9. Fried, Jesse M. & Ganor, Mira, 2006. "Agency Costs of Venture Capitalist Control in Startups," Berkeley Olin Program in Law & Economics, Working Paper Series qt5rz3w67b, Berkeley Olin Program in Law & Economics.
    10. Steven J. Brams & Samuel Merrill, III, 1983. "Equilibrium Strategies for Final-Offer Arbitration: There is no Median Convergence," Management Science, INFORMS, vol. 29(8), pages 927-941, August.
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    13. Georg Nöldeke & Klaus M. Schmidt, 1992. "Option Contracts and Renegotiation - A Solution to the Hold-Up Problem," Discussion Paper Serie A 417, University of Bonn, Germany, revised Aug 1993.
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    15. David E. Bloom & Christopher L. Cavanagh, 1986. "An Analysis of the Selection of Arbitrators," NBER Working Papers 1938, National Bureau of Economic Research, Inc.
    16. Berglof, Erik, 1994. "A Control Theory of Venture Capital Finance," Journal of Law, Economics and Organization, Oxford University Press, vol. 10(2), pages 247-67, October.
    17. Dewatripont, Mathias & Tirole, Jean, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1027-54, November.
    18. Andrei A. Kirilenko, 2001. "Valuation and Control in Venture Finance," Journal of Finance, American Finance Association, vol. 56(2), pages 565-587, 04.
    19. Anthony Downs, 1957. "An Economic Theory of Political Action in a Democracy," Journal of Political Economy, University of Chicago Press, vol. 65, pages 135.
    20. Black, Bernard S. & Gilson, Ronald J., 1998. "Venture capital and the structure of capital markets: banks versus stock markets," Journal of Financial Economics, Elsevier, vol. 47(3), pages 243-277, March.
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    22. Schmidt, Klaus M., 2003. "Convertible Securities and Venture Capital Finance," Munich Reprints in Economics 19769, University of Munich, Department of Economics.
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    Cited by:
    1. Da Rin, M. & Hellmann, T. & Puri, M.L., 2011. "A Survey of Venture Capital Research," Discussion Paper 2011-111, Tilburg University, Center for Economic Research.

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