So far, I have explained that, in a developing country, a controlling shareholder can attain a significant part of non-pecuniary benefits by empire-building. How, then, is empire-building embodied in a concrete way, and what are the implications of empire-building in relation to equity finance?
(a) A Balance Sheet Analysis
In general, “large corporations” are meant to be “corporations with large assets.”68 From an accountant’s perspective, as the size of the assets (i.e., the left side of balance sheet) increases, the sum of the debt and equity (i.e., the right side of balance sheet) should increase to the same extent since both sides of a corporation’s balance sheet are equal. When external capital is required by a corporation, a controlling shareholder may initially prefer to rely on debt (especially bank loans) according to the pecking order theory. During this period, as assets increase, so does
68 What is a “large” corporation? The definition of a large corporation may vary. A large corporation might be a corporation with a large number of “employees,” large “sales” or “assets.” Generally, in developing countries, the number of employees and the magnitude of sales and assets are highly correlated with each other. In that sense, it can be said that the size of the assets is a good proxy for measuring how large a corporation is. In this Article, therefore, when I mean by a large corporation, it is a corporation with a large size of assets.
debt to the same extent, and thus the size of the equity remains. Consequently, a growth strategy that depends solely on debt financing raises the leverage ratio of a business group. As the debt-equity ratio deteriorates, however, the financial distress costs increase.69
Perhaps, “high” leverage may still be sustainable by a corporation even if it creates enormous inefficiency in the capital structure. However, at some point, a controller’s choice to base her empire-building strategy solely on debt financing is generally impractical for two reasons: (1) the financial distress costs of “extremely high” leverage far exceed the benefits such that the corporation is unable to endure; and (2) the debt market would no longer make loans to the corporation due to the fear of default even if the corporation is in search of another debt. Inevitably, a controlling shareholder who seeks empire-building eventually “has to” turn to equity financing from outside investors in the stock market.
Under these circumstances, a “repeat controller” whose child is expected to inherit ought to be concerned about the next equity issuances – thus, she has an incentive to voluntarily protect minority shareholders at least to some degree. True, the frequency of equity issuance is rare in a controlling shareholder system.70 However, the interval between equity financing which looks “long” to a dispersed shareholding firm’s CEO who can remain in that post for only several years is
actually “short” to a controlled firm’s dominant shareholder whose time horizon is
infinite. In sum, the decision to have minority shareholders can be explained by the
69 According to the trade off theory of debt-equity, financial distress costs would increase as debt- equity ratio increases. See Brealey, Meyers, and Allen, supra note 31.
need for capital in the stock market (as opposed to the product market-based account),71 if analysis takes into consideration dynamism, such as the growth of a corporation over a long (or infinite) time horizon through dynastic succession.
One may argue that although the above explanation is true in some situations, a controlling shareholder will not rely on external equities when the new equity threatens her interest as a controller; as a controller’s cash flow rights are diluted by the new equity issuance, her voting rights are injured as well, and she may eventually lose her control over the corporation. As such, a controlling shareholder would not think about the option of going to the equity market in the first place. Perhaps, this argument is relevant in the controlled structure (CS) regime where a typical controlling shareholder is required to have a majority of shares to have control over a corporation; here, a controller may decide to issue new shares as long as she is able to participate in this capital-raising as a dominant investor who can maintain the majority shareholder’s position after the new equity issuance; she would not let the corporation issue new shares, however, if she does not have enough money to participate in the new equity issuance, since new issuance would reduce her equity holding under the critical level for control.
This concern, however, is not very meaningful to a controlling shareholder in the controlling minority structure (CMS). In the CMS, a decrease in cash flow rights does not necessarily dilute a controller’s voting rights in the same proportion, since a controlling shareholder is effectively able to entrench her control position through
71 “The decision to have minority shareholders then can be explained not by the need for capital …, but as a way of developing reputation that will be valuable in the product market…” (emphasis is added). Gilson, supra note 4 at 648.
voting leverage devices.72 Since a CMS controller’s voting rights are not critically reduced by new equity issuance, equity financing is generally seen as a safe means to attain the goal of empire-building.
(b) A Simple Model: A Controller’s Cash Flow Rights and Empire-Building
To what extent, then, can a controlling shareholder enlarge her business when she raises capital from the stock market? If an algebraic relation between the size of assets and a controller’s economic interest exist, what does that tell us? For these answers, suppose that a controlling shareholder contributes money as an equity capital to her controlled corporation, where her economic interest in the corporation is denoted as α (0 ≤ α ≤ 1). Her equity capital is worth A dollars. When the total worth of equity capital in the corporation is E dollars, a controller’s personal equity capital (i.e., Α) is equal to α E – hence, E is equal to (A / α). Note that the debt-to-equity ratio is expressed as λ (for example, when the debt-to-equity ratio is 400 percent, λ is 4); then, the size of the assets of the corporation is equal to (1 + λ) (A / α); this implies that the size of the assets (which is the proxy of the non-pecuniary benefits) and the economic interest of a controller have a reciprocal relationship, given λ and A. Table 2 summarizes above information.
72 Generally, there are three voting leverage devices – stock pyramids, dual-class share structures, and cross-ownership ties. See Bebchuk et al., supra note 18.
Table 2: Reciprocal Relationship between Size of Assets and Economic Interest of a Controller
Notations
- A : the worth of equity capital that a controller contributes to the corporation
- α : the economic interest of a controller
- E : the total value of equity capital in the corporation
- λ : the debt-to-equity ratio of the corporation (e.g., λ = 4 → debt-to-equity ratio =
400%)
The Size of the Assets of the Corporation A = α E Thus, E = [A / α ]
Assets = Equity + Debt = E + λ E = (1 + λ) E = (1 + λ) [A / α]
- There is a reciprocal relationship between the size of the assets of the corporation and the economic interest of a controller, when the debt-to-equity ratio and the worth of equity capital that a controller contributes are constant.
- Since the size of the assets of the corporation is a proxy for the magnitude of non- pecuniary private benefits of control, the above reciprocal relationship can be interpreted in such a way that the non-pecuniary private benefits of control increase rapidly as the economic interest of a controller decreases.
A numerical example explains the relationship between the size of assets and the economic interest of a controller in a more concrete way. Suppose that there are three corporations with three controlling shareholders who invest the same amount of money – 50 million dollars in each corporation. Three controllers hold 100 percent, 50 percent, and 5 percent of common stocks in corporations, respectively – apparently, the first controller runs a CS-style corporation, whereas the third runs a CMS-style corporation.73 Then, the total equity of each corporation should be 50 million dollars, 100 million dollars, and 1 billion dollars, correspondingly. If each corporation is
73 The second controller runs either a CS or a CMS corporation since her economic interest in a corporation is 50 percent. Remember that in this Article, a CS corporation is defined as a corporation where a controller’s economic interest is more than 50 percent. A CMS corporation is a corporation where a controller’s economic interest is less than 50 percent.
allowed to finance debts by 400 percent equity-to-debt ratio (i.e., λ = 4), the total assets of each corporation will be 250 million dollars, 500 million dollars, and 5 billion dollars, respectively.
Although these three controllers contribute the same value of capital, the third controller attains the largest non-pecuniary benefits because she runs the largest corporation. Put differently, in consideration of non-pecuniary private benefits, the
optimal choice for a controller is to maintain the least cash flow rights in the
corporation as long as her control is assured, other things being equal. In addition, it is noteworthy that non-pecuniary benefits (e.g., psychic utility of a controller such as leadership, fame, reputation, social and political influence) are private benefits – although most of the assets (99%) consist of other people’s money (i.e., equity and debt) in the third corporation,74 the only person who is able to consume non- pecuniary benefits exclusively is the third controller. The lesson is clear. Having more external capital from the equity market is ultimately beneficial to a controller in that it increases the territory (i.e., the assets) of her empire – the more equity capital a controller has in her controlled corporation, the more debt she can bring in as well, and the larger corporation she would run, which provides more non-pecuniary benefits to her. 75
74 In Corporation 3, a controller’s capital contributed is 50 million dollars. Since she holds only 5% of equity, the total amount of equity in Corporation 3 is 1 billion dollars. If the corporation’s leverage level (i.e., debt-to-equity ratio) is 400%, as assumed in this example, this would mean that in addition to the 1-billion-dollar equity, there is a 4-billion-dollar debt. Thus, a controller’s equity (50 million dollars) is only 1% of the corporation’s total assets, 5 billion dollars (the sum of equity and debt). 75 Equity financing is essential for attaining more debt from outside. Suppose that the debt-to-equity ratio is maintained at 400%. Then, when a corporation issues 1 million dollars of new equities, it is entitled to have additional 4 million dollars through subsequent debt financing. As the sum of equity and debt increases, the size of firm (the asset size) increases as well – through this empire-building, a
In the numerical example, the third controller who has 95 percent of equity from minority shareholders has an empire that is 20 times larger than that of the first controller who has no minority shareholders at all – according to the aforementioned general model, the size of the assets that the first controller manages is (1 + λ) (A / 1), whereas that of the third controller is (1 + λ) (A / 0.05), which is equal to 20 (1 + λ) (A / 1). Therefore, ceteris paribus, a controller in a developing country may have an incentive to attract minority shareholders since her non-pecuniary benefits are a positive function of the value of equity capital she collects from public shareholders. Table 3 shows a summary of this point.
Table 3: Relationship between a Controller’s Economic Interest in a Corporation and the Size of the Corporate Empire that She Can Control
Corporation 1 Corporation 2 Corporation 3
Amount of a Controller’s Equity
$ 50 million $ 50 million $ 50 million
Controller’s Economic Interest in a Corporation 100 % 50 % 5 % Type of a Corporation’s Ownership CS CS / CMS CMS Total Equity of a Corporation
$ 50 million $ 100 million $ 1 billion Total Debt of a
Corporation76 $ 200 million $ 400 million $ 4 billion
Total Asset Size (Sum of Equity and Debt)
$ 250 million $ 500 million $ 5 billion A controller in Corporation 3 can “rule” an empire 20 times larger than that of a controller in Corporation 1. Accordingly, a controller in Corporation 3 can enjoy much more non- pecuniary private benefits than a controller in Corporation 1 although they both invest the same amount of equity in the corporations.
controller’s non-pecuniary benefits increase. As a result, equity financing is a solid foundation for debt financing and non-pecuniary benefits.