Commitment, Liquidity and Control in Business Organizations

Abstract

In this dissertation I reflect on business organizations, as ways to legally organize economic activities. In Chapter 1, I build on extant literature to define a theory of business organizations that is orthogonal and complementary to the theory of the firm. The central question this theory addresses is: What legal form should a firm take? I argue that the “property turn” that has characterized recent advancements in the theory of the firm has yet to fully take place in the theory of business organizations and attempt to make several steps in that direction. In particular, I show that a central issue for organizations is whether the capital provided by investors is committed for the long period or not. Different organizational forms are characterized by different levels of commitment. Historically, the enforceability of commitments to invest for the long was slow to be granted and involved politically-charged process. Once established, long-term commitment of capital unleashed a series of developments that are now well understood to characterize modern markets. In Chapter 2, I build on these ideas to propose a formal model of the commitment of capital for the long term. In the model, two organizational forms are contrasted: one with short-term capital (a “partnership”) and one with capital committed for the long term (a “corporation”). By starting from this basic difference, I show that a series of implications follow. In particular, investors in the corporation have to compensate the loss of liquidity entailed by the long-term commitment with a more liquid market for shares ex post. In turn, liquidity in the market depends endogenously on the degree of asymmetric information that characterizes trade. Thus, for the commitment of capital to be sustainable, shares have to be liquid, which in turn implies that shareholders need to be (in expectation) relatively uninformed so that outside (fully uninformed) investors do not demand too large a discount when purchasing their shares. This mechanism yields implications for the typical size of different organizational forms, with corporations faring better than partnerships in terms of share value when the number of equity holders is large, and vice versa when it is small. In addition, the separation between ownership and control in large corporations, which is typically seen with preoccupation, emerges endogenously from the model as a necessary feature that guarantees liquidity in the secondary market and, in turn, increases share value in the primary market. In Chapter 3, I apply the model to shed light on the regulation of exit. The commitment of financial resources to a project is essential for long-term investment but brings about both a loss of control and a loss of liquidity for investors. Therefore, investors are ordinarily given an exit option. In this chapter, I contrast three common ways to exit: tradability of one's equity position, liquidation rights and redemption rights. I show that they balance liquidity and control very differently. Large safe projects are better associated with tradability, because the risk of inefficient continuation is low and the market provides enough liquidity. Small risky projects are better associated with redemption rights, because they can sort inefficient liquidations from inefficient continuations. Liquidation rights are desirable when redemption rights fail because of high costs of capital or the risk of runs on the company's cash