Real options and dynamic incentives
We examine a dynamic principal-agent model in which the output follows a Markov process. The agent has private information, not only about the current output, but also about the firm value. The optimal contract determines a payment schedule from the principal to the agent and a liquidation policy. Incentive compatibility, together with the agent's limited liability, requires that the firm is liquidated following a history of low returns.
With correlated outcome, the optimal liquidation decision depends both on the firm profitability and the history of past returns that can be summarized by the agent's continuation value. In the beginning, the agent's continuation value is low and the optimal contract relies on an inefficient liquidation threat to provide the agent incentives.
The payments are delayed, and the agent is rewarded by promising him a higher continuation value for the future. Once the agent's value grows high enough, the firm is operated efficiently. In particular, the firm is only liquidated if it is efficient to do so.