Ambiguity, Disagreement, and Allocation of Control in Firms

We present a novel source of disagreement grounded in decision theory: ambiguity aversion. We show that ambiguity aversion generates endogenous disagreement between a firm's insider and outside shareholders, creating a new rationale for corporate governance systems. In our paper, optimal corporate governance depends on both firm characteristics and the composition of the outsiders' overall portfolio. A strong governance system is desirable when the value of the firm's assets in place, relative to the growth opportunity, is sufficiently small or is sufficiently large, suggesting a corporate governance life cycle. In addition, more diversified outsiders (such as generalist mutual funds) prefer stronger governance, while outsiders with a portfolio heavily invested in the same asset class as the firm (such as venture capitalists or private equity investors) are more willing to tolerate a weak governance system, where the portfolio companies' insiders have more leeway in determining corporate policies. Finally, we find that ambiguity aversion introduces a direct link between the strength of the corporate governance system and firm transparency, whereby firms with weaker governance should also optimally be more opaque.