Corporate form and pay-for-performance contracts

However, as Posner points out, some for-profits receive financial incentives from the government for delivering some public goods. For example, the government subsidizes alternative energy producers.

It’s interesting to examine how the agency theory, which Posner describes in the article, pertains to social impact bonds. Agency theory says that in a model with an entrepreneur, a donor, and a beneficiary, if the entrepreneur runs a for-profit firm, then the money she she has the incentive to keep as much as possible of the money she receives from the donor to deliver as a product to the beneficiary. If the donor gives the entrepreneur $100, with the understanding that the entrepreneur will keep $10 for herself, spend $10 on operations, and deliver $80 to the beneficiary, then the entrepreneur wants to keep more than $10, which means either delivering less than $80 or spending less than $10 on overhead, or both. In a nonprofit, however, the entrepreneur does not get to keep the profit, and therefore has less incentive to underdeliver on the services that she provides to the beneficiary.

Posner writes about the problematic agency relationship: “Technically speaking, this means the entrepreneur sells a product (transferring charitable money to a beneficiary) whose quality (getting 80% to the beneficiary) is nonverifiable, that is, cannot be stipulated in a contract that is enforceable by a court” (p. 2032).

Now imagine an entirely different model, one describing ex-post payment for performance.  In this model, the donor announces his intention to pay to any entrepreneur $100 for each $80-worth of service that she can deliver to the beneficiary.  One example can be a donor willing to pay a company $100 for each $80 vaccine that the latter will purchase, deliver, administer, and document in a developing country.  The entrepreneur has not yet incorporated her efforts in either a nonprofit or for-profit corporate form.  The question of which form to choose now seems less relevant to her.  If she thinks that she can carry out the task by spending, say, $17, then she should expect to get a profit of $3.  If this profit is above her expected opportunity cost (presumably she is choosing from among several projects), then she will take the donor up on his offer; the lower she expects her overhead to be, the greater her profit and the more incentive she has to take the offer.  She should become agnostic about corporate form, since she will simply set her salary at the $100 less the expected overhead.  The only concern is that the salary will appear excessive.  But that seems to be the donors concern, since he is the one who would have lost money he could have otherwise saved by mispricing his offer.

While the entrepreneur is now agnostic about corporate form, the donor is not.  The donor can deduct his gift to a nonprofit, but not to a for-profit, and therefore prefers that the entrepreneur’s efforts take the latter form.