16 2 Funding: Introduction
This means that it is important to the firm to manage outgoing information (for
the distinction between incoming and outgoing information, see Volume I).
Agency relationships. It is characteristic of funding decisions that they are in-
fluenced by agency considerations that are different from those that influence in-
vestment decisions.
First, the management of agency relationships belongs to the core questions of
corporate governance (see Volume I). From the perspective of the firm, the choice
of a funding mix also means the choice of a mix of agents providing a mix of an-
cillary services like monitoring the firm’s management and ensuring the long-term
survival of the firm.
Second, one of the core duties of the firm’s top management, as its agents, is to
decide on the allocation of value and risk between different stakeholders. Many of
them (shareholders, creditors, and asset investors) are providers of funding.
Third, as regards specific funding transactions, the other party is an agent and a
source of counterparty commercial risk. The management of counterparty com-
mercial risk is particularly important for four main reasons: an investor might de-
cide to withdraw its investment, after which the funds will not be available any
more; an investor might transfer its investment to another investor contrary to the
interests of the firm; an investor might have too much say in the management of
the firm; and an investor might exercise its powers to the detriment of the firm.
Agency problems of funding. Mainstream corporate governance scholarship has
focused on the problem of expropriation of outside investors by company insiders.
The existence of conflicting interests and the agent’s risk aversion are some of the
usual causes of agency problems in this context. For example, creditors can typi-
cally incur agency costs because of: claim dilution; asset withdrawal; asset substi-
tution; and underinvestment (see Volume II).^33
There are agency problems even when the firm is regarded as the principal and
providers of funding (and ancillary services) are regarded as its agents. The firm
can incur agency costs because of:
- claim dilution (investing in other projects can mean that the investor will not be
able continue funding the firm or increase the funding); - the withdrawal of funding (it can be difficult or costly to replace the funding ar-
rangement with a new one); - investor substitution (the transferability of claims can reduce the investor’s in-
centives to act in the interests of the firm, and the quality of transferees as in-
vestors and providers of ancillary services can vary);
(^33) The three foundational studies are: Jensen MJ, Meckling WH, Theory of the firm:
Managerial behavior, agency costs and ownership structure, J Fin Econ 3 (1976) pp
305–360; Smith CW, Warner JB, On financial contracting: An analysis of bond cove-
nants, J Fin Econ 7 (1979) pp 117–161; and Myers SC, Determinants of corporate bor-
rowing, J Fin Econ 5 (1977) pp 147–175. See also Bratton WW, Bond Covenants and
Creditor Protection: Economics and Law, Theory and Practice, Substance and Process,
EBOLR 7 (2006) pp 39–87.