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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. We distinguish between two financing modes, namely relationship financing, where the allocation decision of the entrepreneur 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. The rate at which funding is released becomes tighter over time under relationship financing, and looser under arm's length financing. The trade-off in the choice of financing modes is between lack of commitment with relationship financing and information rents with arm's length financing.

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File URL: http://cowles.econ.yale.edu/P/cd/d12b/d1292-r.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 1292R.

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Length: 50 pages
Date of creation: Feb 2001
Date of revision: Oct 2004
Publication status: Published in RAND Journal of Economics (Winter 2005), 70(3): 1107-1033
Handle: RePEc:cwl:cwldpp:1292r

Note: CFP 1176
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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

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References

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