The question of whether corporate law affects firm value has been a long-standing debate. Some believe corporate laws are trivial and have no effect on firm value, but the dominant view argues that corporate laws do affect firm value. Scholars assume that states are competing for incorporations, and market forces lead states to devote different resources to resolving corporate disputes. Theory predicts that when corporate law increases investor protection and reduces agency costs, it will increase firm value. Alternatively, when corporate law caters to management and relaxes rules on investor protection, it should increase agency costs and reduce firm value.
More than half of the US public firms are incorporated in Delaware, and this phenomenon has inspired speculation that Delaware has superior corporate law which increases firm value. However, the empirical evidence on whether Delaware incorporation actually increases firm value is mixed. An influential study, Daines (2001), finds that Delaware firms are worth significantly more than similar firms incorporated elsewhere. He also finds that Delaware firms are more likely to receive a takeover bid and to be acquired. However, subsequent empirical studies have found opposite results. Gompers, Ishii, and Metrick (2003) find that Delaware firms are worth less than non-Delaware firms. Subramanian (2004) finds that the results documented in Daines (2001) are driven by small firms, while the sample used in Gompers et al. (2003) consists of mainly large firms. He shows that small Delaware firms are worth more than small non-Delaware firms during the period 1991-1996, but not afterwards. He also shows that larger firms exhibit no Delaware effect for any year during the period 1991-2002.
A caveat to these studies is that they typically do not directly test corporate law characteristics, even though Delaware is argued (or assumed) to have different laws. Instead, they use a Delaware indicator variable which is a proxy for incorporation choice rather than a direct measure of corporate law characteristics.
What we find
To contribute to the Delaware debate, we use a different measure of valuation to test the effect of incorporation choice on firm value. Prior studies use Tobin’s Q as a measure of firm value. Tobin’s Q is defined as market value of equity deflated by book value of equity, and is commonly interpreted as a measure of a firm’s growth potential. In contrast we use the firm’s implied cost of equity capital to infer firm value. This measure is based on James Ohlson’s theoretical work and is the discount rate which equates the forecasted future earnings of a firm with its current market value (Ohlson 1995). Firm value increases with a lower cost of equity (a lower discount rate).
Moreover, instead of separating firms into Delaware and non-Delaware firms, we classify them into three groups: firms incorporated in their home state (a home-state firm is defined as a firm that incorporates in the state where its corporate headquarters is located), incorporated in Delaware, and those incorporated in other states (neither in their home state nor in Delaware).
We find consistent evidence that firms incorporated in Delaware are worth significantly less than firms incorporated in their home state over the sample period from 1990 to 2006. However, we further show that firms incorporated in other states (neither Delaware firms nor home-state firms) are also worth significantly less than home-state firms, and there is no statistical difference between Delaware firms and firms incorporated in other states. In other words, our study finds that the so-called Delaware effect may simply reflect that there is a positive “home-state” effect on firm value. Furthermore, this home-state effect is consistent across different sizes of firms, i.e. results are not driven by either smaller or larger firms.
In a more direct test of corporate law, we find that some corporate law characteristics affect firm value. For example, firms incorporated in states with more stringent antitakeover statutes have a lower cost of equity.
As a caveat, we note that Delaware firms on average are larger and riskier, and such firms have a higher cost of equity, and higher growth potential (higher Tobin’s Q). It is possible that such firms tend to self-select to Delaware for incorporation, while firms with lower growth potential and a lower implied cost of equity capital are more likely to incorporate in their home state. In other words, incorporation choice/corporate law per se may have no effect on firm value. Even though we use instrumental variables to control for this potential selection bias, this problem cannot be completely ruled out.
Our study contributes another piece of evidence to the Delaware debate. It raises questions about the alleged benefit of Delaware incorporation. Based on our above discussion, we draw the following conclusions. First, Delaware firms and home-state firms are two distinct types of firms. As stated above, Delaware firms are bigger, riskier, and have higher cost of equity capital and higher growth potential; while home-state firms are smaller, less risky, and have lower cost of equity capital and lower growth potential. Second, incorporation choice affects firm value. Other things being equal, incorporating in the home state decreases the cost of equity (implying higher valuation), while incorporating outside the home state, including Delaware, increases the firm’s cost of equity (implying lower valuation).
The observed effect of incorporation choice on firm value is unlikely completely driven by corporate law characteristics. Other factors such as local favoritism and geographical characteristics may also affect the firm’s cost of equity. Nevertheless, our evidence is suggestive that Delaware incorporation (and non-home-state incorporation more generally) has a negatively effect on firm value.
Daines, Robert. 2001. Does Delaware law improve firm value? Journal of Financial Economics 62 (3):525-558.
Gompers, Paul, Joy Ishii, and Andrew Metrick. 2003. Corporate Governance and Equity Prices. The Quarterly Journal of Economics 118 (1):107-155.
Ohlson, J. A. 1995. Earnings, Book Values, and Dividends in Equity Valuation. Contemporary Accounting Research 11 (2):661-687.
Subramanian, Guhan. 2004. The Disappearing Delaware Effect. Journal of Law, Economics & Organization 20 (1):32-59.
This post comes to us from Jere R. Francis, Curators’ Professor and Trulaske Chair at Trulaske College of Business, University of Missouri-Columbia, and Michael D. Yu, Associate Professor of Business at University of West Georgia. The post is based on their forthcoming article in International Journal of Business and Research, which is entitled “Incorporation Choice and Implied Cost of Equity” and is available here.