When investor control makes financing more difficult to secure:-

The general thrust of control rights theory is that investors are reassured, and so are more willing to lend, if they have control rights over the firm. The purpose of this exercise is to build a counterexample in which investor control is self-defeating and jeopardizes financing.

(i) An entrepreneur has cash A and wants to invest I>A into a (fixed-size) project. The project yields R > 0 with probability p and 0 with probability 1 - p.

The probability of success is pH if the entrepreneur behaves and p_L = p_H - ?_p (?p > 0) if the entrepreneur misbehaves. The entrepreneur receives private benefit B > 0 in the latter case, and 0 in the former case. All parties are risk neutral, the entrepreneur is protected by limited liability, and the rate of interest in the economy is 0.

What is the necessary and sufficient condition for the entrepreneur to be able to obtain financing from investors?

(ii) Now add a control right. This control right can raise the expected revenue in the case of misbehavior, but does nothing in the case of good behavior; namely, the holder of the control right can select an action ("damage control") that raises the probability of success from pL to pL + ν (ν > 0) in the case of misbehavior, but keeps pH constant. This interim action imposes a cost γ > 0 on the entrepreneur. (If the action is not selected, the probabilities of success are as in question (i), and there is no private cost γ.) The choice of action is simultaneous (say) with the entrepreneur's choice of effort. First assume "entrepreneur control" (the entrepreneur is given the right to select this action or not). Write the two incentive constraints for the entrepreneur to behave. Show that, compared with question (i), the pledgeable income remains the same ifand is decreased otherwise.

(iii) Next consider "investor control." Assume that when indifferent, the investors select the dominant strategy, i.e., the damage-control action (alternatively, one can assume that the action raises pH as well, to pH+ε, where ε is arbitrarily small). Show that the financing condition is now

Conclude that investor control, besides reducing NPV, may also make it more difficult for the entrepreneur to secure financing.