Unbundling Ownership and Control

• Author: Daniel Ferreira,Emanuel Ornelas,John L. Turner
• Date: 01 March 2015
• DOI: http://doi.org/10.1111/jems.12084
• Published date: 01 March 2015

Unbundling Ownership and Control

DANIEL FERREIRA

Department of Finance

London School of Economics

London, UK

d.ferreira@lse.ac.uk

EMANUEL ORNELAS

Department of Economics

Sao Paulo School of Economics-FGV

Sao Paulo, Brazil

and Department of Management

London School of Economics

London, UK

e.a.ornelas@lse.ac.uk

JOHN L. TURNER

Department of Economics

University of Georgia

Athens, GA

jlturner@terry.uga.edu

We study control contests under asymmetric information. Using a mechanism design approach,

we fully characterize the optimal control contest mechanism. The optimal mechanism requires

increasing the number of shares owned by the incumbent insider if he remains in control, while

giving him a golden parachute that includes both shares and cash if he is deposed. The model

underscores a novel explanation for the prevalence and persistence of the separation of ownership

from control: efficiency in control contests is more easily achieved when ownership of cash flow

rights is not concentrated in the hands of insiders.

1. Introduction

We study control contests in the presence of asymmetric information about managerial

talent. Our goal is to help explain how efficiency in control contests affects,and is affected

by, the relationship between ownership of cash-flow rights and control rights.1To do

so, we consider a model in which managerial talent is the only determinant of the value

of a closely held firm. Examples of closely held firms include entrepreneurial firms,

venture-capital-backed firms, and firms owned by a few private investors.

We th an k Re n ´

ee Adams, J. Amaro de Matos, Yakov Amihud, Ulf Axelson, Jeremy Bulow, Mike Burkart,

Vinicius Carrasco, Gilles Chemla, David Cicero, Mariassunta Giannetti, Harold Mulherin, Walter Novaes,

Clara Raposo, Per Str¨

omberg, and an anonymous referee for very helpful comments and suggestions. Wealso

thank the seminar participants at Maryland, Mannheim, Carlos III, Edinburgh, Nova de Lisboa, Cass Business

School, Imperial College, Stockholm School of Economics, the joint seminars in Helsinki, Queen Mary,Collegio

Carlo Alberto, the CEMAF/ISCTE Finance Conference, the International Industrial Organization Conference,

the European Symposium in Financial Markets at Gerzensee, and the North American Winter Meeting of the

Econometric Society for their comments.

1. Throughout this paper, “ownership” refers to cash-flow rights.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 1, Spring 2015, 1–21

2Journal of Economics & Management Strategy

In this setting, efficiency requires control rights to be assigned to the shareholder

with the highest managerial ability or, equivalently, to the shareholder who is most able

to appoint and monitor managers. To achieve this, a control contest must be incentive

compatible, providing shareholders (who are potential managers) with incentives to

truthfully reveal their private information. As a result of these incentives, shareholders

who participate in a control contest receive informational rents. This may generate

extra costs for agents who buy shares and extra benefits for agents who sell them.

Consequently, it may preclude efficient allocations of control.

We show that the degreeof separation between cash-flow rights and control rights

affects the extent of informational rents. The degree of separation also affects share-

holders’ incentives to participate in the control contest: shareholders who initially own

more shares need a higher expected payoff, in the control contest, to be willing to par-

ticipate. Given the total expected gain from restructuring, there is a trade-off between

providing informational rents for all participating shareholders to induce truth-telling

and ensuring shareholders’ incentives to participate. We identify the degree of separa-

tion between cash-flow rights and control rights that best economizes on this trade-off,

thereby facilitating efficient transfers of control.

Our analysis yields two main contributions: one applied and one theoretical. Our

main contribution to the applied corporate finance literature is the finding that efficiency

in control contests generally requires the unbundling of ownership from control. That

is, the winner of a control contest must not acquire 100% of the cash-flow rights. An

important corollary is that shareholders who lose control must receive compensation

paid in shares (e.g., stock-based “golden parachutes”).

Our main theoretical contribution is the introduction and characterization of the

optimal mechanism that implements efficient transfers of control whenever possible.

Under this mechanism, every shareholder participates and truthfully reports his ability;

control is then allocated to the shareholder with the highest ability. To induce truthful

revelation and voluntary participation, the mechanism determines a rule that allocates

ownership shares conditional on shareholders’ reports. Conditional on using this opti-

mal share rule, we show that efficient control restructuring is easier to achieve when the

controlling shareholder initially owns fewer shares.

We show that the optimal share rule typically maintains some separation of own-

ership from control. To better understand the forces driving the optimal mechanism,

consider the effects of reducing the share allocated to the “winner” of control away from

unity.This has two primary effects. First, it reduces the number of shares that the winner

must buy upon acquiring control; this reduces the informational rents requiredby incen-

tive compatibility.2Second, it reduces shareholders’ expected gains from participating

in the control contest; this effect makes it more difficult to induce all shareholders to

participate. Hence, reducing winning shares away from full ownership affects the pos-

sibility of efficient transfers of control in both positive and negative ways. The optimal

winning shares trade-off these two effects.

For simplicity, we derive our results in a model in which there is only one insider

(the incumbent controlling shareholder) and one outsider (a control contestant). The op-

timal winning shares for insiders and outsiders are qualitatively distinct. For insiders,

2. When winning shares are less than one, expected rents are strictly smaller than under bilateral exchange

(Myerson and Satterthwaite, 1983) or partnership dissolution (Cramton et al., 1987). In one striking case, when

controlis traded but shares are not traded, the mechanism is incentive compatible but there are no informational

rents. In another case, when a shareholder’s “losing” share exceeds his winning share,informational rents are

negative, in the sense that share trading yields a budget surplus for a hypothetical mechanism designer.