The Dynamics of the Management-Shareholder Conflict

Abstract

This article investigates the distribution of equity ownership between entrenched management and dispersed outsiders when management has the ability to manipulate the cash flows and when it is costly for equity holders to prove managerial wrongdoing in court. Management chooses the distribution of equity ownership so as to maximize private benefits against the risk of potential control challenges. When shareholders are long-term oriented, then outside shares trade at a premium over the value to management, and management is inclined to sell off its equity stake to dispersed outsiders. When shareholders are short-term oriented, then outside shares trade at a discount below their value to management, and disciplinary pressure can be substantially reduced via strategic share purchases. Changes in the cost of capital drive a wedge between entrenched management's and dispersed outsider's valuation of shares. Management exercises its option to buy (sell) shares when the option is in the money: when management values shares more (less) than outsiders do.