Berkeley Program in Law and Economics

The financial contracting literature treats control as an indivisible right held either by a firm’s entrepreneurs or by its investors. In contrast, data from VC-backed firms shows that board control is typically shared, with a third-party independent director holding the tie-breaking board seat (‘ID-arbitration’). In this article I use a bargaining game similar to final offer arbitration to model a firm’s choice of action under ID-arbitration. I show that ID-arbitration can reduce holdup by moderating each party’s ex post threat position. Consequently, ID-arbitration can lead to the efficient outcome in circumstances where alternative governance arrangements – entrepreneur control, investor control, or state-contingent control – are either unavailable or likely to lead to suboptimal results. This project has implications for the literature on financial contracting and the theory of the firm.