Which of the following statements is true in the context of principal-agent relationships

5.6 Pay for Performance

A central question in the theoretical research on optimal payment design is how to balance the goals of cost containment and quality assurance. Pure prepayment will generally lead to underprovision of quality unless consumers are well informed about quality and switching costs are low. Optimal mixed payment models may generate second best solutions but payers have been slow to adopt mixed payments. Quality disclosure can increase the elasticity of demand for quality facing each seller, but the empirical evidence suggests that consumer responses to disclosure are modest and that disclosure can have unintended negative consequences.

Agency theory suggests an alternative to mixed payment models and disclosure—direct contracting for quality, or pay for performance (P4P). Research on P4P in health care is motivated by two simple theoretical propositions:

If a principal pays an agent on a “fee for X” basis, then as the fee increases, the agent's production of X will increase. This is a standard incentive story.

Suppose an agent can produce X and Y, where the two are substitutes in production. (That is, producing more of one raises the marginal cost of producing the other.) Then if a principal pays an agent on a “fee for X” basis, then as the fee increases, the agent's production of Y will decrease. This is known as multitasking.

The theory of multitasking is developed by Holmstrom and Milgrom (1991). In addition to introducing the basic concept of multitasking, Holmstrom and Milgrom describe how to optimally design a multitasking contract, the scope of activities to assign to the agent, the grouping of tasks, and the allocation of tasks across agents. To date, the empirical studies of P4P in health care focus on the basic question of whether multitasking occurs and do not address the more advanced subtle issues raised by Holmstrom and Milgrom.

Empirical research on P4P programs began to proliferate in the early 2000s and over 100 studies have been published to date (Van Herck et al., 2010). The studies are of varying quality; many have inadequate controls or involve simultaneous treatments that make it difficult to isolate the effects of P4P (Christianson et al., 2008). Van Herck et al. report that, on average, P4P programs generate small improvements in the targeted processes and outcomes. P4P is especially effective for immunizations and for diabetes care and is generally more effective for process measures than for outcomes. Only a few studies show that performance declined for non-incentivized measures (multitasking).

Mullen et al. (2010) provide a good example of a P4P evaluation. Beginning in 2002, California insurer Pacificare paid bonuses to medical groups that performed at or above the 75th percentile of the previous year's scores on several quality measures. One year later, five other California health plans joined in. The bonuses were potentially substantial—a small medical group could receive up to $30,000 annually in bonus pay. Mullen et al. compare trends in quality measures before and after P4P is implemented using a DID methodology; medical groups in the Pacific Northwest form the comparison group. They find that the effects of P4P are modest at best; only one P4P measure, cervical cancer screening, showed a statistically significant increase relative to trend. Another measure, appropriate asthma medication, showed a significant decrease. Appropriate antibiotic usage, which was not part of the P4P program, also declined. Overall, Mullen et al. fail to find evidence that the P4P program either altered care delivery or improved quality.

The United Kingdom Quality and Outcomes Framework (QOF), introduced in 2004, is the most extensive ongoing P4P program. QOF specifies 80 P4P targets concentrated in three diseases: asthma, diabetes, and heart disease. QOF applies to all primary care practitioners and bonus pay can amount to as much as 30 percent of practice income. In 2009 the UK implemented a parallel program for hospitals, home care, and mental health providers—the Commissioning for Quality and Innovation (CQUIN) payment program. To date, CQUIN payments can add up to 2 percent to hospital reimbursements.

Several studies, including Campbell et al. (2007), McDonald and Roland (2009), and Campbell et al. (2009), report early results of the QOF. They find that the rate of improvement in the quality of care increased for asthma and diabetes immediately after the implementation of QOF, but the rate of improvement subsequently slowed. There was no improvement in care quality for heart disease. The QOF requires physicians to enter data into an electronic medical record and physicians report that the structure of their office visits is often dictated by the requirements of the QOF program. It is therefore not surprising that quality of care on dimensions not included in the QOF declined for asthma and heart disease (multitasking).

P4P programs are likely to proliferate. For example, Medicare proposes using 65 quality metrics in a new P4P program for managed care organizations. Research on P4P is likely to proliferate as well. Studies to date have confirmed both the standard incentive story and multitasking. There have been no strong welfare conclusions. Nor have researchers used results to improve P4P design by implementing concepts in Holmstrom and Milgrom. This may require a more structural approach that allows researchers to identify the underlying utility and cost parameters essential to optimal contract design.

Agency theory

Agency theory has become the dominant theoretical framework in English-language corporate governance studies (Shleifer and Vishny, 1997). Berle and Means (1932) argue that the agency problem stems from the separation of ownership and control in modern corporations, which gives rise to information asymmetry between managers and the shareholders. The managers (agents) possess more expertise than the shareholders (principals), thus giving them more latitude for self-interested behaviour (Shleifer and Vishny, 1997). The goals the agents pursue are therefore sometimes not aligned with those of the principals. The costs resulting from managers misusing their position, as well as the costs of monitoring and disciplining them to try to prevent abuse, have been called ‘agency costs’ (Blair, 1995). As a consequence, one of the important mechanisms of corporate governance is control of the agency problem in order to increase productivity and managerial efficiency (Fama and Jensen, 1983).

Ownership structure and the boards are two crucial internal governance factors in resolving conflicts between owners and managers (Denis and Kruse, 2000; Liu, 2006). Ownership structure is instrumental in aligning the interests between shareholders and managers, while the board can exert influence on the behaviour of managers to ensure that the company is run in their interests. These two issues are discussed below.

Board of directors

The agency theory states that the board of directors is the primary internal control mechanism. The board of directors provides services to a firm’s principals to monitor the behaviour of the managerial staff. Waldo (1985) and Fleischer et al. (1988) argue that the main tasks of a board of directors are: (1) monitoring managerial behaviour on behalf of the firm’s owners; (2) formulating strategic decisions about firm activities; (3) detecting managerial misconduct and removing the relevant managers.

Macey and O’Hara (2003) argue that there are two duties that are incumbent on a firm’s board of directors: duty of care and duty of loyalty. Even though banking institutions have the same responsibilities as non-banking firms, the boards of directors of banking institutions have additional responsibilities, which take the form of guidance, laws, and regulations. These extra responsibilities concern bank stability.

BCBS (1999) states that boards of directors in the banking sector play vital roles in creating good corporate governance. The corporate governance process involves: (1) setting up and enforcing clear lines of responsibility and accountability throughout the organization; (2) making sure that all members of the board are qualified and very clear on the role they undertake in corporate governance, and that they are free from interference from management or outsiders (special committees should be set up to look into risk management, auditing, financial compensation, and nomination); (3) making sure that financial compensation is in accordance with the ethical values, objectives, strategy, and control of the bank and that all managers and key personnel are motivated to work in the best interests of the bank; (4) making sure that corporate governance is conducted in a transparent way (more specifically, relevant information such as board management structures, organization structure, incentive structure, and transactions carried out by the bank should be disclosed to affiliates and related parties); (5) establishing strategic objectives, guiding corporate values, and preventing anything that could have a negative impact on the quality of corporate governance such as corruption, self-dealing, and giving favors to related parties; (6) making use of internal and external auditors effectively as an integral part of the control system.

9.3.2 Entrepreneurs

In agency theory, informational asymmetry problems may allow entrepreneurs to engage in opportunistic behaviors. As a result, an important task of the principal (shareholders) is to device corporate governance mechanisms that minimize adverse selection and moral hazard problems (Arthurs & Busenitz, 2003). However, in an information economics perspective, particularly high-quality entrepreneurs can (and do) also take actions that reduce information asymmetry problems related to their own abilities, the quality of their projects, and the prospects of their firms.

One important way entrepreneurs can reduce potential adverse selection issues, for example, is through signaling—where entrepreneurs provide credible pieces of information on firms’ unobservable quality and intentions including strategic moves (e.g., Connelly, Certo, Ireland, & Reutzel, 2011; Porter, 1980). As indicated in Table 9.1, signaling by entrepreneurs may serve as an internal, informal governance mechanism that gets activated as entrepreneurs engage in the acquisition of equity crowdfunding (or other external resources). Because entrepreneurs may have incentives to positively bias information or withhold negative information when they search for external financial resources, simply stating that they are “good” or of high quality will not be effective (Amit et al., 1998). In signaling theory (Spence, 1973), which has its roots in information economics as well, observable attributes function as a credible signal of unobservable quality, when these attributes are correlated with unobservable quality and are costly or difficult to obtain for low-quality firms relative to high-quality firms. Thus by signaling, high-quality entrepreneurs can potentially differentiate their firms from low-quality entrepreneurs, thereby reducing adverse selection issues.

Extensive research has shown how entrepreneurs and managers engage in signaling to ease resource attraction, for example, when making decisions about their boards’ structures by having prominent board members (e.g., Certo, 2003; Certo et al., 2001) and with endorsement relationships, including prominent VC investors and alliance partners (e.g., Colombo et al., 2018; Stuart, Hoang, & Hybels, 1999), among others. Equity crowdfunding research further suggests that entrepreneurs signal unobservable firm quality to equity crowdinvestors, aiming to increase their fundraising success (Chapter 10: Signaling in equity crowdfunding, and Chapter 12: Cash-flow and voting rights in equity crowdfunding; see also Vismara, 2016; Vulkan et al., 2016). One consistent finding, for instance, is that when entrepreneurs retain more equity, this serves as an important signal that positively impacts the probability of funding success (Chapter 10: Signaling in equity crowdfunding, and Chapter 12: Cash-flow and voting rights in equity crowdfunding; Vismara, 2016). Moreover, Chapter 10: Signaling in equity crowdfunding shows that when entrepreneurs provide more detailed information about risks they increase the probability of funding success. Vismara (2016) also shows that social capital influences the probability of funding success.

Nevertheless, existing studies on equity crowdfunding—just like signaling studies in the management literature more broadly—examine how signals influence resource attraction, but this does not provide direct evidence that these signals are effective mechanisms in reducing adverse selection issues. Further, existing research has not fully leveraged insights from signaling theory in information economics. More specifically, for signals to separate high-quality from low-quality entrepreneurs and their firms, the signal’s expectations (i.e., the correlation between the observable characteristic and unobservable quality) should eventually get confirmed (Bergh, Connelly, Ketchen, & Shannon, 2014). However, we lack evidence on whether specific signals are eventually correlated with firm success and might be an effective governance tool for entrepreneurs to reduce adverse selection concerns. The growing availability of data in the crowdfunding context should allow scholars to address these important issues in future studies and provides the potential to make important contributions to signaling theory as well.

Moreover, as detailed earlier, existing studies have shown how entrepreneurs can signal with prominent broad members, or prominent exchange partners (Certo, 2003; Stuart et al., 1999). An important question that remains, however, is how entrepreneurs of very early stage firms can assemble the resources needed to attract managerial talent or prominent affiliates and stack their boards with industry leaders (e.g., Shane, 2003) with which entrepreneurs can signal their unobservable quality. Moreover, many early stage firms do not have formal boards (Uhlaner et al., 2007). Given these factors, the equity crowdfunding context provides an ideal setting in which to examine these important issues. Chapter 10: Signaling in equity crowdfunding, for instance, presents evidence that equity crowdinvestors also rely on “cheap talk” or nonbinding, nonverifiable, and costless claims made by entrepreneurs (Farrell & Rabin, 1996). Specifically, claims by entrepreneurs that they envisage an initial public offering (IPO) exit (48% of entrepreneurs in their sample do) increases the odds of a successful equity crowdfunding campaign. This finding suggests that equity crowdinvestors rely not only on credible signals but also on other types of communication. Thus there is a possibility that equity crowdinvestors react to communications that do not present the facts, which may actually foster adverse selection problems in the equity crowdfunding context. This evidence provides opportunities for further research that examines how entrepreneurs combine credible signaling and other forms of communication, why the investors would rely on cheap talk, and when different types of signals or other types of communications become more impactful for subsequent resource attraction and firm success.

Finally, just like equity crowdfunding studies have focused on possible signaling by entrepreneurs around the time of the equity crowdfunding campaign (e.g., Chapter 10: Signaling in equity crowdfunding), entrepreneurial finance scholars have generally investigated signaling around specific events, including VC fundraising or an IPO (e.g., Certo, 2003; Colombo et al., 2018; Ko & McKelvie, 2018). However, more substantive actions that relate to firm professionalization with which entrepreneurs signaled to raise early funds, such as setting up a formal board of directors, may have a more long-standing impact on firm behavior and success. Moreover, high-quality entrepreneurs may have incentives to engage in signaling across time, and low-quality entrepreneurs can also (deliberately or not) provide signals that reveal their true nature (Arthurs and Busenitz, 2003). For instance, by providing timely and accurate information and professionalizing their boards, high-quality entrepreneurs can signal their trustworthiness. By doing so, these entrepreneurs can also reduce the need for formal governance mechanisms discussed earlier. However, the question remains how equity crowdinvestors can take corrective actions when they receive signals of low-quality, inappropriate behavior, or suboptimal behavior after the investment has taken place. Given that crowdinvestors obtain shares that are illiquid and cannot be easily traded, this suggests that while signaling by entrepreneurs may be a valuable informal governance mechanism, it is not sufficient by itself to minimize moral hazard problems (Table 9.1).

3.2. Patients, doctors, and insurers as principals and agents

Thus far, we have implicitly assumed that patients choose the amount of medical care they want, knowing their illness, the range of possible treatments, and the prices of the treatments to them. But few patients are so well informed. In most cases of serious expenditure, it is the doctors who make the resource-spending decision, with patients and insurers bearing the costs; patients usually do not know the charge until the bill comes. Patients, physicians, and insurers are in a principal–agent relationship: the patient (principal) expects the doctor (agent) to act in his best interest when he is sick. Similarly, the insurer would like the doctor to act in its interests. Of course, patients also bear the insurance costs for seeking care, so that ex ante the patient's incentives and the insurer's incentives line up. But once the patient becomes sick and requires care, the parties’ incentives diverge.

This three-player agency problem creates substantial problems for health insurance. To the extent that medical treatments are decided upon jointly by physicians and patients, the supply side of the health insurance policy (the rules about paying physicians) will matter along with the demand-side of the insurance policy (the rules about cost sharing for patients).

With the traditional service-benefit insurance policy, doctors and patients frequently have relatively congruent interests, which may differ from those of the insurer. Patients who face but a fraction of the costs they incur will desire excessive treatments. Service-benefit insurers usually pay more to physicians who provide more medical services. The result is that patients and physicians want essentially all care that improves health, respectively ignoring and welcoming resource expenditures. The view that physicians should do only what is best for the patient is codified in the Hippocratic Oath – providers should promote the best medical outcomes for their patients. Hippocrates said nothing about providing care the patient or society would have deemed ex ante to be wasteful.

Plato anticipated the application of agency theory to the health care arena by a goodly margin. He wrote that, “No physician, insofar as he is a physician, considers his own good in what he prescribes, but the good of his patient; for the true physician is also a ruler having the human body as a subject, and is not a mere moneymaker” (The Republic, Book 1, 342-D).25 With the passage of 2,000+ years, fidelity to principals has slipped a bit, and new participants – insurers, government, employers, and provider organizations – have strode into the arena. But the principles are very much the same.

A more sinister view of the principal–agent problem contends that physicians manipulate patients into receiving more services than they would want, so that physicians can increase their income. This has been termed supplier-induced demand in the literature. An enormous amount of work in health economics has been devoted to the question of whether and to what extent suppliers induce demand. The empirical evidence on this issue is discussed by McGuire (2000). Lesson 1 notes the tradeoff between risk spreading and appropriate incentives applies on both the demand- and supply-sides of the market.

Increasingly, the arrows of responsibility among the players – who is agent, who principal – now point in all directions. For example, doctors now have responsibilities to other providers and insurers, not just to patients. Such added doctor responsibilities, primarily to hold down expenditures, ultimately enhance patient welfare, at least on an expected value basis, if not when the patient is sick. Insurers, acting for their customers as a whole, want to limit spending to only that care that is necessary; i.e., the care patients would select given a lump-sum transfer that depends on their condition and making them pay all costs at the margin. With patients, physicians and insurers pulling in different directions, a conflict over what care will be provided frequently results.

2.2.4 Overconfidence

A final – and potentially very promising – agency theory of investment builds on the premise that managers are likely to be overly optimistic about the prospects of those assets that are under their control. That such overconfidence exists at the individual level has been repeatedly established in the psychology literature.20 Moreover, unlike in the asset-pricing arena, one cannot easily appeal to arbitrage considerations to argue that the effects of individual-level overconfidence will not show up in aggregate corporate investment.

Roll (1986) is one of the first papers to explicitly introduce overconfidence into a corporate-finance context.21 Roll argues that managerial “hubris” can explain a particular form of overinvestment, namely overpayment by acquiring firms in takeovers, but his general logic would seem to carry over to other forms of investment as well. Malmendier and Tate (2002a) provide evidence consistent with Roll’s theory.

More recently, Heaton (2002) demonstrates that an overconfidence model can deliver not only a broad tendency towards overinvestment, but also many of the liquidity-constraints-type patterns associated with the costly-external finance models reviewed in Section 2.1. Heaton’s insight is that when managers make overly optimistic assessments of their firms’ prospects, they will be reluctant to issue new equity, as the stock price will often seem unfairly low to them. This leads to very much the same conclusions as in Myers–Majluf (1984) – there will be little external equity financing, and investment will increase with internal resources.22 Thus, an assumption of overconfidence can be an alternative and relatively parsimonious way to generate a reduced form that looks very much like the unified empire-building/costly-external-finance model summarized in Equation (3). This idea is explored empirically by Malmendier and Tate (2002b).

One reason for taking overconfidence seriously in a corporate-finance setting is that, compared to other agency problems, it is likely to be relatively impervious to some of the obvious remedies. This is because overconfident managers will think that they are acting benevolently on behalf of shareholders, even though from the perspective of objective outsiders their decisions may destroy value. As a result, the distortions associated with overconfidence cannot be easily resolved by, e.g., giving managers higher-powered incentive contracts.

2.2. Excessive Risk Taking

A second source of instability of the banking system relates to risk taking on the asset side. As is well known from agency theory, in a principal–agency relationship the objectives of the involved parties are not perfectly aligned, so the agent does not always act in the best interest of the principal. The problem can be limited by designing appropriate incentive schemes for the agent or by controlling his decisions through costly monitoring. In general, though, the divergence of interests will not be completely resolved, at least not at zero cost. Applying these arguments to corporate finance, it is easy to see that there is a misalignment in the objectives of debt holders and firm managers. Even if all parties are utility maximizers, their attitude toward risks diverges. Whereas debt holders bear the downside risk, the manager pursuing shareholders’ interests benefit from upside potential. Thus, the manager has strong incentives to engage in activities that have very high payoffs but very low success probabilities (Jensen and Meckling 1976).

While this agency problem is present in all leveraged firms, two features of the banking system make it more severe among banks. First, the opacity and the long maturity of banks’ assets make it easier to cover any misallocation of resources, at least in the short run. Second, the wide dispersion of bank debt among small, uninformed (and often fully insured) investors prevents any effective discipline on banks. Thus, because banks can behave less prudently without being easily detected or paying additional funding costs, they have stronger incentives to take risk than firms in other industries.

To illustrate the agency problem between banks and depositors, we use a simple model adapted from Holmstrom and Tirole (1997), Cerasi and Daltung (2000), and Carletti (2004). Consider a two-date economy (T = 0,1), in which at date 0 a bank invests in a project, which yields a return R if successful and 0 if unsuccessful. The success probability of the project depends on the monitoring effort m ∈ [0,1] that the bank exerts. It is pH if the bank monitors and pL if it does not, with pH >pL, Δp = pH> – pL, and pHR> 1 > pLR. Monitoring is costly; an effort m entails a private cost C(m)=c2m2. The choice of the monitoring effort depends crucially on the financing structure of the bank. If it is self-financed, it chooses m so as to maximize its expected profit.

Π=mpHR+(1−m)pLR−y−c2m2,

where y represents the return on an alternative safe investment. In this case the first-order condition gives

m=ΔpR c.

By contrast, if the bank raises external funds in the form of debt with promised (gross) return rD, it chooses m so as to maximize

Π=mpH(R−rD)+(1−m)pL(R−rD) −c2m2.

The first-order condition is then given by

m=Δp(R−rD)c.

Clearly, raising deposits reduces the equilibrium monitoring effort. The reason is that the bank now has to share the benefit of greater monitoring with depositors. If the deposit rate is set before m is chosen, increasing monitoring simply raises the probability of repaying depositors without reducing the funding costs. This worsens the bank's incentive and leads to a lower equilibrium effort.

2.2 Recent Work: The Rise of Agency Theory

Modern scholarship has produced more precise insights about when delegation benefits those who delegate. Many scholars now adopt the language of principal–agent models (i.e., agency theory) to describe the logic of delegation.

The principal in principal–agent theories represents someone who delegates. The agent represents someone to whom authority is delegated. When a lawmaker delegates authority to an agency, for example, the lawmaker is the principal and the agency is the agent.

Scholars use principal–agent models to determine when agents do (and do not) act in their principals' interests. Agency loss provides a common metric for their distinctions. Agency loss is the difference between the consequences of delegation for the principal and the best possible consequence. Agency loss is zero when the agent takes actions that are entirely consistent with the principal's interests. As the agent's actions diverge from the principal's interests, agency loss increases. When the agent does things that are bad for the principal, agency loss is high.

Research on delegation (see, e.g., Lupia and McCubbins 1998) shows that agency loss is minimized when two statements are true. The first statement is that the principal and agent share common interests (Niskanen 1971, Romer and Rosenthal 1978). In other words, the principal and agent desire the same outcomes. The second statement is that the principal is knowledgeable about the consequences of the agent's activities. In other words, principals know enough about their agents' actions to determine whether or not these actions serve their interests.

If either of these two statements is false, then agency loss is likely to arise. Agency loss arises when the agent and principal do not have common interests because the agent gains an incentive to act against the principal's interests. If a liberal lawmaker delegates to conservative civil servants, for example, then the agents have less of an incentive to pursue the lawmaker's favored policies than they would if they were also liberals. Agency loss arises when the principal lacks knowledge about an agent's activities because the agent can act against the principal's interests without the principal being aware of the indiscretion. If, for example, lawmakers asks the police to enforce a restriction on public drunkenness, but lack information about agency activities, then the police may not fear retribution if they choose not to enforce the restriction (see Gerber et al. 2001 for examples).

Agency loss is even more likely if neither of the two statements is true. In other words, when principals have conflicting interests with agents whose activities they cannot know, delegation is likely to be abdication. The threats are greatest in these situations because agents have both an incentive and an opportunity to act against the principal's interests without fear of retribution.

When comparing the main themes of modern and early work on delegation, we see that many early scholars reached their dour conclusions because they presumed that the two statements described above were false. More recent work disputes this presumption, uncovering the many ways in which principals can induce their agents to have common interests and learn about their agents' activities. While the new work does not totally contradict the idea that delegation can become abdication, it is more precise about when this negative outcome occurs.

A central theme in recent literature shows how principals design political institutions to affect the incentives and future actions of their agents. McCubbins et al. (1987), for example, examine how legislative decisions about the structure of political institutions affect the extent of agency loss. Drawing on a wide array of actual administrative procedures, they show that lawmakers can and do set rules for agents that reduce agency loss by ensuring that people who share their policy interests are able to influence what agents do. For example, lawmakers often not only require agents to file extensive reports on their activities, but also invite interested parties from outside the agency to do the same. These interested parties are chosen because they are known to share the lawmakers' policy preferences—including them in the process makes agents more attentive to the lawmakers' policy desires. Many studies also show how lawmakers attempt to reduce agency loss by choosing agents who share their interests (i.e., by making civil service appointments on a strictly political basis: see Epstein and O'Halloran 1999 and Laffont and Tirole 1993 for reviews of such findings).

Discussion questions

12.1.

What are the potential advantages associated with the separation of ownership and control? What are the potential disadvantages? Explain, with reference to various agency problems outlined in Chapter 2, Overview of agency and signaling theory in crowdfunding. Do you think these advantages and disadvantages would be more pronounced in the context of equity crowdfunding? Why?

What is the typical ownership share offered in crowdfunding campaigns such as those on Crowdcube? Does offering a higher ownership share improve the probability that the offering will be successful? Does a higher ownership share improve long-run success? Explain, with reference to theory and evidence.

What is the typical extent to which ownership is separated from voting rights in crowdfunding campaigns on Crowdcube? Does offering a greater separation of ownership and control improve the probability that the offering will be successful? Does a greater separation of ownership and control improve long-run success? Explain, with reference to theory and evidence.

What are the typical threshold amounts used to obtain voting shares in crowdfunding campaigns on the Crowdcube crowdfunding platform? What affects the decision to set thresholds of different amounts? Explain with reference to theory and evidence.

What explains the entrepreneur’s choice of use of Crowdcube versus one of the other equity crowdfunding platforms in the United Kingdom? Why?

What explains the decision to issue A-shares versus B-shares on Crowdcube? Why?

What explains the extent to which equity shares are sold on equity crowdfunding platforms such as Crowdcube? Is the extent to which equity is sold correlated with the extent to which there is a separation of ownership versus control through the issuance of nonvoting shares via Crowdcube? Explain with reference to theory and evidence.

Do professional investors prefer voting or nonvoting shares on the Crowdcube equity crowdfunding platform? Why? Explain with reference to empirical evidence.

How important is founder experience for campaign success, and for long-run success of an equity crowdfunded company? Explain with reference to empirical evidence.

Do tax schemes such as SEIS facilitate successful equity crowdfunded companies? Why? Explain with reference to theory and evidence. What does the evidence say about complementarities (or lack thereof) in the design of public policy for entrepreneurial finance? (See also Chapter 17: Public policy toward entrepreneurial finance: spillovers and scale-up.)

Rise of Agency Theory

Throughout the latter half of the 1970s and into the 1980s there was a slow continued interest in corporate governance and transparency. Although many major reforms in corporate governance were still to come, during this period in particular there was a renewed interest in an economic theory called agency theory. Specifically, the works of Michael Jensen and William Mecklin in 1976 and later of Nobel laureate Eugene Fama in the 1980s are examples of the rising interest in this area (Farazmand, 2002).

Agency theory is a branch of neoclassical economics that has been applied to the management of corporations (Lawrence, 2010). In an agency relationship there are two groups of parties. One party is the owners or principals of an organization, and in a corporate context these would be the shareholders. The other party is the agents or managers of the organizations.

One of the central tenants of agency theory relates to the so-called agency problem or the principal–agent problem. Agents need principals and vice versa. As a general rule, shareholders do not possess the requisite skills to run corporations and principals need shareholders’ investments to run the corporation (Schroeder et al., 2010). Despite this symbiotic relationship, a problem persists that presents a continued risk to the shareholders. Their agents, the management, may possess inherently different goals than the shareholders. Specifically, shareholders are generally interested in a firm’s overall profitability. In the academic literature of corporate governance this is sometimes referred to as shareholder value theory (Stelios, 2012). Managers may, in economic speak, seek to maximize their own utility. This translates to making certain choices that may be in the management’s best interest, but not in the best interest of the shareholders.

Not everyone has been a fan of agency theory. Similar to those who have levied criticism on the links between governance and social responsibility, others have argued that agency theory does not necessarily reflect the realities of corporate governance. Some of these criticisms include that the analytical models of the principal–agent relationship are too simplistic as compared with the real-world challenges of implementing such relationships in practice (Predergast, 1999). Others have criticized what are known as the adverse selection problems that arise in agency theory due to the control and access to asymmetrical information among the principals and the agents (Iris, 2006). Certainly such criticisms have direct corollaries to the imperfect flow of information among hedge funds, their directors, and investors, among others, in the hedge fund food chain. We will revisit the link between these agency theory criticisms and hedge fund governance with a particular focus on the board of directors in more detail in Chapter 2; however, for now simply note that this is an example of the link between the roots of traditional corporate governance and hedge fund governance.

Regardless of whether you believe in the benefits of agency theory or not, the rise in popularity of agency theory also played a critical role in shareholders’ push for enhanced corporate governance reforms to come throughout the 1980s and into the 1990s.