Financing Constraints, Performance Manipulation, and Founder Replacement

Granting investors the right to replace founders with professional managers benefits founders ex ante through improved financing terms or access to funding that would otherwise be unavailable. Ex post, however, founders prefer to remain in charge and have incentives to manipulate the performance metrics that trigger their replacement. When founders are financially unconstrained, the optimal contract eliminates manipulation incentives through generous exit packages. When founders are financially constrained, however, such packages leave insufficient pledgeable income to satisfy investors. Constrained founders must therefore offer contracts that induce them to manipulate performance metrics in equilibrium, leading to insufficient founder replacement. The model predicts that lower capital requirements, from technological shifts such as cloud computing, and greater founder wealth lead to larger exit packages, less manipulation, and more frequent turnover. In technologically complex sectors where performance metrics are opaque, exit packages are smaller, manipulation is more prevalent, and replacement is less frequent. The framework extends to staged financing, where founders distort the interim signals that inform follow-on funding decisions, undermining the standard benefit of staging.