The role of ownership on control right allocation and compensation contract design

Abstract

We propose a corporate control model that deals with control right allocation and compensation contract design. By drawing upon a special feature of human nature, that is the sense of gain and loss affiliated with initial ownership as described by the prospect theory in Kahneman and Tversky (1979), we find that it helps mitigate the inefficiency stemming from the agency problem. In particular, there exists a most desirable level of ‘managerial irrationality’ that completely offsets the social efficiency loss inflicted by the moral hazard problem. Moreover, less control right should be allocated to outside investors and more compensation should be granted to the manager as the latter reveals more serious concern about his ownership gain and loss.

Notes

¹According to Tirole (2006, p. 387), control right is defined to be ‘the right for a party or groups of parties to affect the course of action in certain circumstances once the firm has gotten started’. The importance of control rights in corporate finance was first introduced by Aghion and Bolton (1992) and then developed by Hart (1995) and Hart and Moore (1998).

²There exist two solutions of (α,e) that satisfy both ‘IC’ and ‘IR’ constraints. However, only the (α,e) solution with a larger value is selected.

³Based on specified parameters, δ* equals 0.32 when β = 0.5. Therefore, for those δs greater than 0.32 there is no iteration process and the threshold φ is larger than 1.

⁴This iteration process may not converge because the incremental change in γ _k is not fine enough or the number of control rights is not large enough.