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Control Rights and Maturity: The Design of Debt, Equity, and Convertible Securities

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  • Zsuzsanna Fluck
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    Abstract

    This paper investigates the design of the control rights and the maturity of securities when management has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as court, to verify or prove any managerial wrongdoing. By endogenizing claim structures, control rights and maturity, I derive a diverse set of optimal contracts. Debt with a maturity shorter than the life of the assets is sustainable when investors have the contingent right to liquidate the firm's assets. Long-term debt can be sustained by investors' right to dismiss management and take over the firm as a going-concern in the event of a default. Investors are willing to hold indefinite life equity if they are granted either the unconditional right to liquidate firm's assets or the unconditional right to dismiss management. Finally, convertible debt can be sustained by investors' right to dismiss management and take over the firm in the event of default by the holder's option to convert their debt contract to an equity contract prior to its expiration date. Consistent with empirical evidence, this model predicts that small entrepreneurial firms use short term bank loans, convertible debt, or outside equity at their initial financing stage; as they show evidence of higher profitability, they can secure longer-term financing.

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    Bibliographic Info

    Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 98-035.

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    Date of creation: 15 Nov 1997
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    Handle: RePEc:fth:nystfi:98-035

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    Postal: U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126
    Phone: (212) 998-0100
    Web page: http://w4.stern.nyu.edu/finance/
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