“Entrenchment and Investment” by Ronald Masulis
University of New South Wales
Nanyang Technological University
This paper shows that restrictions on the issuance of non-voting shares may cause managers who own equity in the firm to under-invest. When a firm issues voting shares, there is a dilution in the incumbent manager's control rights. This increases the risk to the manager's control of the firm, decreasing his chances of extracting private benefits of control. Thus, the manager may find it optimal to forgo positive NPV investments in an effort to maximize his expected wealth. Non-voting shares allow a firm to raise funds without any dilution in the manager's control rights; hence, it helps to alleviate the under-investment problem. There are costs to the issuance of non-voting shares: Non-voting shares facilitate entrenchment and thereby adversely affect value-enhancing future takeover activities. Also, use of non-voting shares dilutes dividends, because relative to voting shares firms need to issue a larger number of non-voting shares to raise the same level of funds. We obtain conditions under which the benefit of using non-voting shares – higher firm value due to higher investment – outweighs its entrenchment and dilution costs. Others have shown that deviations from "one share-one vote" can be optimal, but our paper is the first to integrate the dual-class decision into the rich body of research on capital structure and under-investment. Our theory is consistent with the empirical findings of Faccio and Masulis (2005) who find fear of loss of control makes managers reluctant to issue voting shares to finance M&A activities. In addition, our model produces a number of new empirical predictions.