A Theory of Firm Decline

We study the problem of an investor that buys an equity stake in a entrepreneurial venture, under the assumption that the former cannot monitor the latter's operations. The dynamics implied by the optimal incentive scheme is rich and quite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision becomes costlier as inside equity grows. In turn, this leads to a decline in the constrained-efficient level of effort and therefore to a drop in the return to investment. In the long run, the entrepreneur gains control of all cash-flow rights and the capital stock converges to a constant value.