Tore E. Leite

A Pecking Order of Venture Capital Exits

We develop a model of exits from venture capital backed companies based on post-exit moral hazard. It captures the trade-off between the two most important exit choices: IPOs and trade sales. The model shows that highly profitable companies that need few oversight will go public, while less profitable companies that require more control will be sold in a trade sale. This suggests that the common notion that IPOs per se are more profitable than sales is wrong and observed returns suffer from a measurement bias. This is consistent with empirical evidence that IPOs have indeed higher rates of return than trade sales.

Optimal Financial Structure: An Incomplete Contracting Model

The financial structures of firms observed in practice typically consist of debt claims of different priority and maturity, and outside equity with unconditional control. A simple model is developed in which this type of complex financial structure arises endogenously as a mechanism to allocate control and cash flow rights among the firms manager and its investors. While short-term debt commits the manager to liquidate the firm in low profit states, outside equity with unconditional control allows investors to seize control in states where the manager otherwise would pursue low profit projects with high private benefits of control. Finally, long-term (junior) debt creates a debt overhang that protects the manager from excessive shareholder involvement. Copyright 2001 by The editors of the Scandinavian Journal of Economics.

Capital Structure Under Costly Enforcement

We consider financial structure and repayment behavior in a setting where cash flows are private information to the entrepreneur and the cost of enforcing repayment differs across security holders. If enforcement costs are lower for shareholders than for creditors, a mixed capital structure with debt and equity can obtain in equilibrium. Under a mixed capital structure, creditors intervene in low cash-flow states while shareholders intervene in high cash-flow states. Moreover, strategic defaults, costly bankruptcy, shareholder intervention, and violation of absolute priority occur with positive probability on the equilibrium path. Several of the predictions from our framework are consistent with evidence not readily explainable by existing theories.

Security Choice and Expected Announcement Returns

This paper analyzes the relationship between the announcement effects of debt and equity offerings and firms’ choice between debt, equity, and not issuing. The model implies that the equilibrium security is the security that yields the least negative announcement effect, which – contrary to the pecking order hypothesis – may be debt or equity, depending on parameter values. Nonetheless, the model implies that the announcement effect of debt offers observed empirically will be less negative compared to equity offers, consistent with empirical evidence widely interpreted as consistent with the pecking order hypothesis.This paper examines security choice and announcement returns under asymmetric information. Consistent with empirical evidence widely cited in support of the pecking order hypothesis, the model predicts equity issues to be associated with negative announcement returns, and debt issues to be associated with zero or less negative announcement returns. Yet, contrary to the main prediction of the hypothesis of debt preference, the preferred security may be debt or equity, depending on parameter values.