Is It Always Optimal to “Sell the Firm” to a Risk-Neutral Agent?

The paper shows that the answer is no. Holmstrom (1979) and Shavell (1979) show that the sellthe firm contract does not achieve the first best when the principal and the agent have different preferences over risk. This paper shows that the sell the firm contract does not achieve the first best when the principal and the agent have different preferences over time. In a dynamic decision making problem under uncertainty, if the agent's discount factor is less than the principal's, the agent will choose actions with relatively higher current payoffs and relatively lower continuation payoffs than the principal would prefer, even when the agent is sold the firm. When current and future payoffs are correlated, the principal can do better by offering the agent a contract that is even higher powered than the “sell the firm” contract. The paper shows that the principal can align the agent's incentives over time by offering the agent stock options. At their exercise date stock options are a liquid asset that pay the agent in the current period for the future value of his actions. [PDF 202KB]