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The Financing of Innovation: Learning and Stopping

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Abstract

This paper considers the financing of a research project under uncertainty about the time of completion and the probability of eventual success. The uncertainty about future success gradually diminishes with the arrival of addtional funding. The entrepreneur controls the funds and can divert them. We distinguish between relationship financing, meaning that the entrepreneur's allocation of the funds is observable, and arm's length financing, where it is unobservable. We find that equilibrium funding stops altogether too early relative to the efficient stopping time in both financing modes. We characterize the optimal contracts and equilibrium funding decisions. The financial constraints will typically become tighter over time under relationship finance, and looser under arm's length financing. The trade-off is that while relationship financing may require smaller information rents, arm's length financing amounts to an implicit commitment to a finite funding horizon. The lack of such a commitment under relationship financing implies that the sustainable release of funds eventually slows down. We obtain the surprising result that arm's length contracts are preferable in a Pareto sense.

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File URL: http://cowles.econ.yale.edu/P/cd/d12b/d1292.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1292.

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Length: 41 pages
Date of creation: Feb 2001
Date of revision:
Handle: RePEc:cwl:cwldpp:1292

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Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA
Phone: (203) 432-3702
Fax: (203) 432-6167
Web page: http://cowles.econ.yale.edu/
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

Related research

Keywords: Innovation; venture capital; relationship financing; arm's length financing; learning; time-consistency; stopping; renegotiation; Markov perfect equilibrium;

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  8. AMBEC, Stefan & POITEVIN, Michel, 2001. "Organizational Design of R&D Activities," Cahiers de recherche 2001-12, Universite de Montreal, Departement de sciences economiques.
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