Knowledge that Transforms

This paper provides a new explanation for the use of convertible securities in venture capital. A key property of convertible preferred equity is that it allocates different cash flow rights, depending on whether exit occurs by acquisition or IPO. The paper builds a model with double moral hazard, where both the entrepreneur and the venture capitalist provide value-adding effort. The optimal contract gives the venture capitalist more cash flow rights in acquisitions than IPOs. This explains the use of convertible preferred equity, including automatic conversion at IPO. Contingent control rights are also important for achieving efficient exit decisions.

Not necessarily: a firm's fundamental value increases with uncertainty about average future profitability, and this uncertainty was unusually high in the late 1990s. After calibrating a stock valuation model that takes this uncertainty into account, we compute the level of uncertainty that is needed to match the observed Nasdaq valuations at their peak. The uncertainty we obtain seems plausible because it matches not only the high level but also the high volatility of Nasdaq stock prices. In general, we argue that the level and volatility of stock prices are positively linked through firm-specific uncertainty about average future profitability.

The treatment of this article renders closed-form density approximation feasible for univariate continuous-time models. Implementation methodology depends directly on the parametric-form of the drift and the diffusion of the primitive process and not on its transformation to a unit-variance process. Offering methodological convenience, the approximation method relies on numerically evaluating one-dimensional integrals and circumvents existing dependence on intractable multidimensional integrals. Density-based inferences can now be drawn for a broader set of models of equity volatility. Our empirical results provide insights on crucial outstanding issues related to the rank-ordering of continuous-time stochastic volatility models, the absence or presence of nonlinearities in the drift function, and the desirability of pursuing more flexible diffusion function specifications.

We study the consumption-portfolio problem in a setting with capital gain taxes and multiple risky stocks to understand how short selling influences portfolio choice with a shorting-the-box restriction. Our analysis uncovers a novel trading flexibility strategy whereby, to minimize future tax-induced trading costs, the investor optimally shorts one of the stocks (or equivalently, buys put options) even when no stock has an embedded gain. Alternatively, an imperfect form of shorting the box can reduce aggregate equity exposure ex post. Given these two short selling strategies, it is common for an unconstrained investor to short some equity while a constrained investor holds a positive investment in all stocks. With no shorting, the benefit of trading separately in multiple stocks is not economically significant.

Valuation theory says that expected stock returns are related to three variables: the book-to-market equity ratio (Bt/Mt), expected profitability, and expected investment. Given Bt/Mt and expected profitability, higher expected rates of investment imply lower expected returns. But controlling for the other two variables, more profitable firms have higher expected returns, as do firms with higher Bt/Mt. These predictions are confirmed in our tests.

Using proxy data on all Fortune-500 firms during 1994–2000, we find that family ownership creates value only when the founder serves as CEO of the family firm or as Chairman with a hired CEO. Dual share classes, pyramids, and voting agreements reduce the founder's premium. When descendants serve as CEOs, firm value is destroyed. Our findings suggest that the classic owner-manager conflict in nonfamily firms is more costly than the conflict between family and nonfamily shareholders in founder-CEO firms. However, the conflict between family and nonfamily shareholders in descendant-CEO firms is more costly than the owner-manager conflict in nonfamily firms.

Contrary to Miller and Modigliani [1961. Dividend policy, growth, and the valuation of shares. Journal of Business 34, 411–433], payout policy is not irrelevant and investment policy is not the sole determinant of value, even in frictionless markets. MM ask “Do companies with generous distribution policies consistently sell at a premium above those with niggardly payouts?” But MM's analysis does not address this question because the joint effect of their assumptions is to mandate 100% free cash flow payout in every period, thereby rendering “niggardly payouts” infeasible and forcing distributions to a global optimum. Irrelevance obtains, but in an economically vacuous sense because the firm's opportunity set is artificially constrained to payout policies that fully distribute free cash flow. When MM's assumptions are relaxed to allow retention, payout policy matters in exactly the same sense that investment policy does. Moreover (i) the standard Fisherian model is empirically refutable, predicting that firms will make large payouts in present value terms, (ii) only when payout policy is optimized will the present value of distributions equal the PV of project cash flows, (iii) the NPV rule for investments is not sufficient to ensure value maximization, rather an analogous rule for payout policy is also necessary, and (iv) Black's [1976. The dividend puzzle. Journal of Portfolio Management 2, 5–8] “dividend puzzle” is a non-puzzle because it is rooted in the mistaken idea that MM's irrelevance theorem applies to payout/retention decisions, which it does not.

We test the predictions of dividend signaling models using closed-end equity funds that adopt explicit policies committing them to pay minimum dividend yields. These policies represent deliberate attempts to reduce share price undervaluation relative to NAV. Funds that adopt minimum dividend policies experience reductions in their share price discounts, trade at smaller discounts than other funds, earn greater excess returns following policy adoption, and their managers survive longer than other managers do. The results are broadly consistent with the predictions of dividend signaling models, and suggest that high quality closed-end funds can reduce undervaluation via dividend policy.

We extend Baker and Wurgler's [2004a. Journal of Finance 59 1125–1165] catering theory to include decreases and increases in existing dividends. Consistent with our extended model, we find that the decision to change the dividend and the magnitude of the change depend on the premium that the capital market places on dividends. We also find that the stock market reaction to dividend changes depends on the dividend premium. Thus, the capital market rewards managers for considering investor demand for dividends when making decisions about the level of dividends.

Consistent with a life-cycle theory of dividends, the fraction of publicly traded industrial firms that pay dividends is high when retained earnings are a large portion of total equity (and of total assets) and falls to near zero when most equity is contributed rather than earned. We observe a highly significant relation between the decision to pay dividends and the earned/contributed capital mix, controlling for profitability, growth, firm size, total equity, cash balances, and dividend history, a relation that also holds for dividend initiations and omissions. In our regressions, the mix of earned/contributed capital has a quantitatively greater impact than measures of profitability and growth opportunities. We document a massive increase in firms with negative retained earnings (from 11.8% of industrials in 1978 to 50.2% in 2002). Controlling for the earned/contributed capital mix, firms with negative retained earnings show virtually no change in their propensity to pay dividends from the mid-1970s to 2002, while those whose earned equity makes them reasonable candidates to pay dividends have a propensity reduction that is twice the overall reduction in Fama and French [2000, Journal of Financial Economics 76, 549–582]. Finally, our simulations show that, if well-established firms had not paid dividends, their cash balances would be enormous and their long-term debt trivial, thus granting extreme discretion to managers of these mature firms.