We study the role of debt in solving the hold-up problem in a buyer-seller relationship by committing the seller not to trade at a low price. Debt renegotiations and verifiability of the cash flow are the key factors in our analysis that determine the effectiveness of debt. We characterize the renegotiation proof dynamic debt contract that maximizes the seller’s profit, and show that the strategic effect of debt is stronger, but debt capacity is lower, if the creditors have a weak position in debt renegotiations.
Our findings are closely related to the literature on the strategic use of debt in bilateral bargaining. The earlier contribution by Baldwin (1983) showed that debt could affect the firm value in industries with sunk-cost technology, where a labor union exploits the sunk-costs and demands a high wage to capture part of the returns to capital. Sarig (1988, 1998), Dasgupta and Sengupta (1993), Perotti and Spier (1993) showed that substituting debt for equity is advantageous for the firm because it reduces the divisible surplus in bargaining. A closely related literature, initiated by the well-known paper by Brander and Lewis (1986), studies the effects of leverage on product market competition and emphasized the role of debt as a valuable commitment device in making the debtors more aggressive competitors. See also Glazer (1994), and Showalter (1995).
More recently, closer attention has been paid to the impact of contract renegotiation on the design and commitment value of financial contracts. Chemla and Faure-Grimaud (2001) adopt a non-verifiable cash flow model to show that a durable good monopolist can benefit from the commitment value of debt to solve the durable good incentive problem. Regarding debt and product market competition, Faure-Grimaud (2000) showed how debt renegotiations weaken the strategic effect of debt when profits are unobservable.
These papers use static models, where term structure of the debt contract does not play a significant role. However, following Hart and Moore (1994), much effort has been devoted to studying the dynamic properties of financial contracting. Commonly, a model in this line of literature has an entrepreneur “who has an idea but no money and an investor who has money but no idea.”3 The possibility of renegotiations at a future date and issues of verifiability of the project’s returns are given the central stage in this line of research.
Our paper focuses on the commitment value of debt in a multi-period buyer-seller relationship, and puts the emphasis on renegotiation (of the debt contract) and verifiability (of the project returns). To simplify we assume that only the seller makes an up front relationship-specific investment. Without a long term contract, the terms of trade will be determined by ex post bargaining in the beginning of each period. Once the seller invests, the buyer can obtain a low price close to the seller’s variable cost, especially if he has considerable bargaining power. (He may threaten not to trade unless the seller accepts a price close to variable cost.) At a low price, the seller is still better off with trade, but makes a loss on the initial investment.
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Optimal debt contracts with non-verifiable cash flow and renegotiation
