Facebook: Main Street to Wall Street

Facebook is filing IPO documents this week. Even though CEO Mark Zuckerberg appears to appreciate status updates more than stock brokers, this milestone in Facebook’s lifecycle marks the changed nature of Facebook as a company. How? A new paper by Booth School’s Raghuram G. Rajan (2012) explains the relation between a firm, its business model and its financing structure. The paper explains why corporate finance is central to innovation and growth, and how the availability of finance influences the nature of the firm.

According to Modigliani & Miller (1958), in a perfect frictionless world a firm’s capital structure is irrelevant to its value. If transaction costs exist, then firms exist (Coase 1937) and capital structure matters to the nature of the firm and the extent of innovation by the firm in particular.
Following upfront financing, Rajan argues, firms undergo two important transformations over their early life:

  • Differentiation, where the entrepreneur creates an organization of people and assets they work with, to produce distinctive goods and services, or use distinctive production methods or address distinctive customer segments. Sustainable differentiation is critical to being able to create net present value. The associated risk and uncertainty makes it difficult for the entrepreneur to get collaborators to commit. Rajan shows that the initial capital structure, with the entrepreneur having significant ownership of assets (distinctive tools and methods, IPR, regulatory protection, the entrepreneur’s human capital) is intended to enable this differentiation while enhancing coordination through giving collaborators the incentive to follow. Since the liquidation value of the differentiated firm is low, the financier doesn’t have much incentive to invest.
  • Standardization, a second transformation where the firm’s operations are standardized and human capital is made more replaceable and liquid. The entrepreneur becomes a replaceable CEO. In contrast with the first, this second transformation builds a powerful incentive for the financier to invest, since standardization gives the financier more effective rights over going-concern surplus based on his treat of replacing the now liquid human capital managing the firm. Outside investors gain more control over the firm hence they can appropriate value. Finance (old finance or new needs) requires successful start-ups to grow up and standardize what they do well, and the entrepreneur has an incentive to make this happen. It is the entrepreneur’s prospect of capturing rents from future CEOs, reflected in the elevated price of her shares at IPO, that makes her forego her direct rents today.

Standardization in the lower ranks of the firm’s organizational hierarchy strengthens the CEO’s operational control, and the value the CEO can appropriate. Standardization in top management strengthens outside control and value appropriation by the shareholders of the firm. The higher the level of standardization in top management, the higher the value appropriated by equity, especially since such standardization is difficult to reverse.

Rajan explains that, while making the venture easier to finance, standardization has the downside of dis-incentivizing employee effort and innovation (by eliminating surplus that can be appropriated by employees in the differentiated firm).
Although mature firms depend less on outside financing of innovation, the standardization that brought them where they are to repay past finance reduces their innovation capability. Furthermore, it is not clear why headquarters, burdened by legacy business, should invest more effectively than outside financiers. Greater tolerance for failure and soft budget constraints will reduce discipline imposed on the intrapreneur. Although it is harder for mature companies to innovate, they can be more effective in defending innovations and patent clusters, and commercialize innovations acquired through M&A.

The strategy of the VC is to finance the entrepreneur in the early days of the venture since he knows the entrepreneur has the incentive to standardize later, and if the expected value of his equity compensates the risk of financing upfront. To make that strategy viable, the VC has to leave the entrepreneur enough of a stake, which is the entrepreneur’s incentive to develop the company and to standardize it. The VC brings experience to the table to support the entrepreneur’s standardization efforts towards IPO (or other exit).
For the VC it is critical that the collective of all assets is not replaceable, although he wants the entrepreneur/CEO to be replaceable. In the other case, the entrepreneur can replicate the venture after leaving. Therefore, a venture relying mainly on human capital of the entrepreneur is unlikely to find VC backing at all. The typical VC backed firm owns a strong underlying technology, innovative business model that is hard to replicate, or brand. Standardization of those sources of differentiation implies embedding that intellectual property in formal patents and trademarks.

On the venture’s preferred capital structure, Rajan states:

Standardization cannot increase debt value beyond its face value, while an increase in standardization will always increase equity value.

Obviously, contractual cash payments to a debtholder are not desired by a start-up that carries high risk. But Rajan’s model shows a second strategic reason why equity financing is desired by the entrepreneur: only in case of equity financing will she reap the fruit of her standardization effort at the IPO. Rajan explains this is due to the difference between ownership rights and control:

Outside equity […] has ownership but delegates control, with the right to take it back (that is, replace the entrepreneur/CEO) at any time. […] With debt finance, the creditor obtains ownership and control only if the firm cannot pay the pre-determined debt payments.

Thus the venture is initially financed with equity. In later financing rounds, debt financing has the benefit of avoiding dilution of old equity, though insolvency risk and takeover risk eventually limits debt financing.

In recent decades, deregulation and liberalization of product and service markets, globalization of trade and capital flows, and abundance of finance have made assets more easily replicable, while coordination costs have been reduced through information and communication technology. As physical asset based control diminished, CEO and employees increased control (and value appropriation) to the disadvantage of the shareholder. Incentives are aligned by use of equity based compensation across flattened organization hierarchies. Brand names and patents increasingly become the key assets around which firms are built. The proliferation of MVNOs and handset OEMs in the telecoms industry, companies that realize huge sales with very few physical assets, are examples demonstrating that ownership of physical assets has become a less important source of differentiation. Obviously, that differentiation has to be created elsewhere, if it is not in the manufacture of the handset or the unique network technology. Lowered coordination costs create the option of forming alliances or value networks coordinating between firms. The successful entrepreneur of tomorrow has to differentiate more, with a lower ability to promise the investor an adequate return (since human capital is more critical compared to physical capital).

Innovation, standardization and finance are linked. As firms grow older, the emphasis shifts from elements of differentiation (technology) to elements of commonality (organization, sales, marketing, HR, finance). The IPO will reward the entrepreneur and the VC for giving control over the firm to floating equity.

I wish you all the best, Facebook.

Coase R. H. (1937) The Nature of the Firm. Economica 4(16): 386-405

Modigliani F., Miller H. M. (1958) The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review 48(3):261-297

Rajan R. G. (2012) The Corporation in Finance. Chicago Booth Research Paper No. 12-02; Fama-Miller Working Paper; IGM Working Paper No. 69. January 12, 2012

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