A theory of pyramidal ownership

In many countries, individuals own multiple firms through complex ownership structures. Despite this fact, the literature on ownership has concentrated on one firm in isolation. I propose two simple, stylized structures —pyramidal and horizontal— as a starting point to think about the ownership structure of multiple firms. Then I present a model in which an entrepreneur has the option of setting up a new firm either in a pyramidal structure (as a subsidiary of a firm he already controls) or in a horizontal structure (as an independent concern). The model is based on a novel — although rather obvious— consideration that differentiates the two structures: in the pyramidal structure the entrepreneur shares the verifiable value of the new firm with the other shareholders of the parent firm, while in the horizontal structure he captures this value entirely. Even if the new firm is a profitable project, extraction of private benefits from it might reduce revenue so as to make the verifiable value negative. In such a case, the entrepreneur chooses the pyramidal structure in order to allocate part of this value to the other shareholders of the parent firm. The model has several implications which are consistent with available empirical evidence. It predicts a higher incidence of pyramidal structures in countries with poor investor protection in accordance with the evidence presented by La Porta, Lopez de Silanes and Shleifer (1998).