Oliver Hart Prize Lecture: Incomplete Contracts and Control

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The Nobel Prizes

profits and the investor in states of the world where profits are important relative 

to private benefits. To the extent that private benefits do not vary much with the 

state, but profits do, this suggests that the investor should have control in bad 

states of the world. In a bad state the manager may want to keep the company 

going to preserve her private benefits even if the assets could have much greater 

value if deployed elsewhere.

Significant support for the Aghion-Bolton model can be found in Kaplan 

and Stromberg’s work on venture capital contracts (see Kaplan and Stromberg 

(2003)). Kaplan and Stromberg study start-up deals in the information technol-

ogy, software, and telecommunication sectors. They find that the allocation of 

voting and control rights is frequently made contingent on verifiable measures 

of financial performance. For instance, the venture capitalist may obtain voting 

or board control if the firm’s earnings before interest and taxes fall below a pre-

specified level or if the firm’s net worth falls below a threshold. If the firm per-

forms poorly, the venture capitalist obtains full control. As firm performance 

improves, the entrepreneur retains/obtains more control rights, and, if the firm 

performs very well, the venture capitalist relinquishes most of his control rights.

One interesting feature of both the Aghion-Bolton model and the Kaplan-

Stromberg study is that control does not shift to the investor as a result of the 

manager’s failure to make a promised payment. Rather control shifts because a 

particular state of the world occurs. In other words, the financial contract does not 

correspond to a classic debt contract. In the venture capital context one reason for 

this may be that start-ups do not generate significant cash flows for a while. Still 

debt contracts are ubiquitous in other settings and it is desirable to explain them.

One attempt to do so is contained in Hart and Moore (1998) and Hart and 

Moore (1994).

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 In Hart and Moore (1998), the assumption that monetary 

returns are verifiable and transferable is dropped. Instead it is supposed that 

the manager can walk off with them. What can persuade the manager to pay 

over some of these cash flows to the investor is that the investor has a threat: he 

can seize the assets underlying the project and liquidate them. Here liquidation 

means using the assets in some second-best manner, perhaps for some other 

activity or with a different manager. (It could refer to a sale of the assets.)

In this setting, Hart and Moore (1998) show that a debt contract works well. 

With a debt contract the manager of the coal mine promises to make a fixed 

stream of payments to the investor. As long as these payments are made the 

manager remains in charge, that is, she retains (residual rights of) control over 

the coal mine. If a payment is not made control shifts to the investor, who can 

decide whether to liquidate the mine. At this stage renegotiation is possible.

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Incomplete Contracts and Control 

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The motivation for the manager to make a debt payment is very simple: 

she wants to retain control of the assets. Why is control valuable? Because the 

manager can use the assets to produce future monetary returns that she can then 

pocket. To put it another way, there are two reasons why the manager may default 

on a debt payment. One is if she cannot make the payment: revenue is too small 

as a result of an adverse shock, say. This corresponds to an involuntary default. 

The other reason is that the manager does not want to make the payment. In turn 

there can be two explanations for this. The first is that future revenues, which 

the manager can pocket, are worth less than what she is being asked to pay. For 

example, suppose that the assets will last for one more period and will generate 

$100, but the current debt payment is $120. (Ignore discounting.) It is not worth 

it for the manager to pay $120 to be able to earn $100 in the future; it is better to 

default and pocket the $120 now. The second explanation is that, even though 

the debt payment is less than the future revenues (say the debt payment is $80), 

the manager may be able to default and renegotiate the payment down to close 

to the liquidation value of the assets (which might be $60).

These last cases, where the manager can pay but won’t pay, correspond to a 

voluntary or strategic default.

This model has several interesting features. First, it shows how important 

collateral is. An investor will be less concerned about strategic default if the 

liquidation value of the assets is high, since the manager cannot renegotiate the 

debt below this level. Thus the manager will be able to borrow more in this case 

and more good projects can go forward. Similarly, if the assets are durable—

their liquidation value remains high over time—the maturity of the debt can be 

longer: the investor will not be vulnerable to strategic debt renegotiation late in 

the project’s life. Empirical support for both these predictions has been obtained 

by Benmelech (2009) and Benmelech and Bergman (2008).

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Second, the model has the feature that inefficient liquidation can occur. Go 

back to the numerical example where the assets generate $100 next period, the 

current debt payment is $80, and the liquidation value is $60. Suppose that cur-

rent revenue is $40. Clearly the manager will default since her $40 does not cover 

the debt payment. The investor can liquidate for $60 but the assets are worth 

more than this—$100—if they are left in place. In an ideal world, a Coasian 

renegotiation would ensure that the assets are indeed left in place. In such a 

renegotiation the manager would compensate the investor for the $60 liquida-

tion value that he gives up by promising part of next period’s $100. However, the 

parties are not operating in an ideal world. The promise to pay part of the $100 

next period is not credible. Since this is the end of the project, and the assets will 

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