Ramy Elitzur

Contracting, signaling, and moral hazard: a model of entrepreneurs, ‘angels,’ and venture capitalists

Abstract Investment by wealthy individuals, known as ‘angels,’ in startup firms is quite significant and has taken off in the last few years. Angels invest in the company at an earlier stage than venture capitalists (VCs) do. This paper examines the relationship between an entrepreneur, an angel, and a VC from the seed investment made by the angel to the exit stage. The study characterizes the equilibrium contracts among the players and provides insights into the related institutional arrangements. Next, the study examines the signaling aspects of the game. The paper also analyzes the moral hazard problems of the entrepreneur and the VC. It shows that the outcome in a startup firm is not efficient because of the free-rider phenomenon.

Transfer pricing rules and corporate tax competition

Abstract A multinational parent sells a non-marketed commodity to a foreign subsidiary that uses the product as an input to produce a product it then sells. The subsidiary is controlled by a local managing partner whose compensation consists of a lump-sum payment plus a share of the subsidiarys profit. The parent chooses an optimal transfer price taking into account incentives for the subsidiarys managing partner and taxes. Home and host governments impose corporate income taxes on the parent and subsidiarys respective profits subject to a transfer pricing rule (e.g. cost plus price method or comparable profit method). A Nash equilibrium is derived for effective tax rates chosen by home and host governments. We then examine harmonization and suggest that tax rates would be reduced.

Game theory as a tool for understanding information services outsourcing

In recent years, game theory has provided valuable insights into many different types of organizational arrangements. In this paper we investigate some of the ways in which game theory can help us to understand the structure and function of information systems outsourcing arrangements. We provide a brief review of two-person non-cooperative game theory. We discuss the basic concepts of dominance and Nash equilibria. In particular we stress the importance of the information structure of two-person games. We then provide a general game-theoretic interpretation of many key aspects of information systems outsourcing arrangements. In particular, we investigate the rationales behind many of the different ways of determining fees and the effects of the transfer of assets between the outsourcing company and the outsourcing vendor. Finally, we discuss how one particular type of non-cooperative two-person game might be useful as a model of information systems outsourcing arrangements. This model, the principal-agent model, has been extensively studied and in the hands of the authors has provided some initial insights into information systems outsourcing arrangements.

Planned audit quality

Abstract Our study was motivated by suggestions to impose mandatory rotation of independent auditors and by the passing of a bill by the U.S. Congress which reduces the auditors civil liability for audit failure. We offer a multiperiod model for the planning of optimal audit quality by external auditors, and examine five propositions concerning the relations between planned audit quality and: 1) the auditors relative efficiency, 2) audit fees, and 3) the expected loss due to audit failure. The major results suggest that: 1) cet. par. efficient independent auditors will plan a higher level of audit quality than less efficient independent auditors, 2) higher audit fees will result in an increase in the planned audit quality level for all expected engagement periods except the final one, and that 3) irrespective of the penalty regime, the level of planned audit quality will diminish over time. It is possible to motivate the auditor to plan a higher audit quality level for the last engagement period by increasing the penalty for audit failure in that period. Such a strategy will result, however, in reduced planned audit quality levels in all periods prior to the final one. Although the analysis increases our understanding about the above relations, it is not sufficient to conclude whether the newly-enacted tort reform is socially desirable.

Executive incentive compensation and earnings manipulation in a multi-period setting

Abstract This study examines in a multi-period setting how trading of equity securities by managers and the awarding of such securities to managers affects earnings manipulation. The study explores the effect of an executive incentive compensation plan, comprised of bonus and equity holdings, on the reporting strategy of the manager under different degrees of market efficiency. The findings indicate that insider trading provides an informative signal about the direction of earnings manipulation. Furthermore, the results confirm that the choice of compensation scheme by owners tends to affect earnings manipulation.

A multi-period game theoretic model of venture capitalists and entrepreneurs

As venture capitalists (VCs) have an important role in financial start-ups, most studies have focused on venture capital as a short-term source of financing. The authors examine the relation between a VC and an entrepreneur in a multi-period game in which the contract is set at the beginning of the game, and follows the relation from its start to the end. This multi-period game theoretic model focuses on the problem of moral hazard – the entrepreneurs hidden effort and how a VC can cope with it, using staged investments. First a game between a VC and an entrepreneur is presented, in which the VC is unable to notice the entrepreneur’s effort. Next, a multi-period game between the parties is examined, where the contract is established at the beginning of the multi-period game. The results of the model are presented, and several propositions and theorems are advanced. The multi-period aspects of the model allow for deriving the strategic behavior of the VCs and entrepreneurs over time. The model is consistent with reality, where the average duration of the relation between venture capitalists and entrepreneurs is several years and the investment is made in stages. The study provides insights on optimal contracts and the characterization of an endogenous exit point. It is suggested that the optimal incentive scheme back load all incentive payments to the entrepreneur, and a straight debt contract is optimal in venture financing. Recommendations are made for further studies on the contracts among VCs who syndicate together, as well as the bargaining between the VC and the entrepreneur.(CBS)

Managerial incentives and the structure of management buyouts

Abstract Management buyouts often occur when incumbent managers have large equity interests in the pre-buyout firms and are typically structured so that managers can increase their share of the outstanding common stock while reducing their dollar investment in the post-buyout firms. We provide a rationale for such observations and develop a model to examine a managers decisions on the structuring of a buyout, and how the structure of a buyout influences a managers efforts in the post-buyout firm.

Optimal control in homogeneous projects: analytically solvable deterministic cases

Abstract We develop a model for determining the economically optimal amount of control effort required to manage a homogeneous project (one consisting of a large number of similar activities). The model is formulated in terms of the losses generated by deviations from the plan and of the costs associated with carrying out control activities. It accounts for changing levels of project activities and includes parameters that represent control effectiveness and project management effectiveness. The model is studied by applying optimal control theory, which yields the optimal control effort described by a number of control functions and switching points at which they change over. We identify three analytically solvable cases for the most commonly used forms of control cost and deviation loss functions. Our analysis of the model leads to several specific conclusions regarding the extent and timing of managerial attention that should be devoted to keep projects on track. We also point out how the optimal off-line policy can be adapted for on-line control and real-time decision making throughout the project life cycle.

Further Thoughts on Information Structure, Knowledge Management and Outsourcing

In the early years of the 1990s we were lucky enough to have the opportunity of investigating the outsourcing phenomenon from a game theoretic perspective. In the first place outsourcing relationships involve interactions between parties that are strategic in nature. The outcome of an action by one party is influenced by the action taken by the other party. We felt strongly that the tools available to us from game theory would provide some rich insights into the nature of the types of contract that would need to be written to provide appropriate incentives to both parties in an outsourcing agreement. It seemed to us that, in spite of the extensive rhetoric, outsourcing was basically still a relationship between two parties with different preferences. This combined with the fact that there were inevitable information asymmetries between the two parties would inevitably lead to incentive problems.

Audit Fees Post-SOX: An Auction Model

The literature shows that audit fees have increased after the SOX ban to audit clients on non-audit services (NAS) but the reason behind it has been unclear until now. Using an auction modeling approach, this study aims to bridge this gap by providing a theoretical explanation for this enigma. In the first auction setting, auditors can compete for both auditing and NAS (the pre-SOX setting). We then investigate how the auction would look when auditors can compete on either auditing or NAS (the post-SOX setting). We show that audit fees will be higher in the post-SOX setting than the pre-SOX one. Furthermore, we show that the SOX ban on NAS would actually make auditors better off than before if NAS budgets remain at, or exceed, the pre-SOX amounts. This result holds even if NAS budgets were reduced but not drastically.