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The financing of innovation : learning and stopping

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Author Info
Bergemann, D.
Hege, U. (Tilburg University, Center for Economic Research)

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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 additional 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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Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 16.

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Date of creation: 2001
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Handle: RePEc:dgr:kubcen:200116

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Find related papers by JEL classification:
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
D92 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Firm Choice and Growth, Investment, or Financing
G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Chan, Yuk-Shee & Siegel, Daniel R & Thakor, Anjan V, 1990. "Learning, Corporate Control and Performance Requirements in Venture Capital Contracts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(2), pages 365-81, May. [Downloadable!] (restricted)
  2. Qian, Yingyi & Xu, Chenggang, 1998. "Innovation and Bureaucracy under Soft and Hard Budget Constraints," Review of Economic Studies, Blackwell Publishing, vol. 65(1), pages 151-64, January. [Downloadable!] (restricted)
  3. Hart, Oliver & Moore, John, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 841-79, November. [Downloadable!] (restricted)
    Other versions:
  4. Bergemann, Dirk & Hege, Ulrich, 1998. "Venture capital financing, moral hazard, and learning," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 703-735, August. [Downloadable!] (restricted)
    Other versions:
  5. Neher, Darwin V, 1999. "Staged Financing: An Agency Perspective," Review of Economic Studies, Blackwell Publishing, vol. 66(2), pages 255-74, April. [Downloadable!] (restricted)
  6. Allen N. Berger & Gregory F. Udell, 1998. "The economics of small business finance: the roles of private equity and debt markets in the financial growth cycle," Finance and Economics Discussion Series 1998-15, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  7. Repullo, R. & Suarez, J., 1998. "Venture Capital Finance: a Security Design Approach," Papers 9804, Centro de Estudios Monetarios Y Financieros-.
    Other versions:
  8. Maskin, Eric & Tirole, Jean, 1990. "The Principal-Agent Relationship with an Informed Principal: The Case of Private Values," Econometrica, Econometric Society, vol. 58(2), pages 379-409, March. [Downloadable!] (restricted)
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  12. Steven N. Kaplan & Per Stromberg, 2000. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," NBER Working Papers 7660, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  13. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, vol. 27(2), pages 473-521, October. [Downloadable!] (restricted)
  14. Farrell, Joseph & Maskin, Eric, 1989. "Renegotiation in repeated games," Games and Economic Behavior, Elsevier, vol. 1(4), pages 327-360, December. [Downloadable!] (restricted)
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  15. Fudenberg, Drew & Tirole, Jean, 1990. "Moral Hazard and Renegotiation in Agency Contracts," Econometrica, Econometric Society, vol. 58(6), pages 1279-1319, November. [Downloadable!] (restricted)
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  16. Christopher B. Barry, 1994. "New Directions in Research on Venture Capital Finance," Financial Management, Financial Management Association, vol. 23(3), Fall.
  17. Stefan Ambec & Michel Poitevin, 2001. "Organizational Design of R&D activities," CSEF Working Papers 60, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy. [Downloadable!]
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  18. Berger, Allen N & Udell, Gregory F, 1995. "Relationship Lending and Lines of Credit in Small Firm Finance," Journal of Business, University of Chicago Press, vol. 68(3), pages 351-81, July. [Downloadable!] (restricted)
  19. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February. [Downloadable!] (restricted)
  20. Fluck, Zsuzsanna, 1998. "Optimal Financial Contracting: Debt versus Outside Equity," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 11(2), pages 383-418.
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  23. Oliver Hart & John Moore, 1998. "Default And Renegotiation: A Dynamic Model Of Debt," The Quarterly Journal of Economics, MIT Press, vol. 113(1), pages 1-41, February. [Downloadable!] (restricted)
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  24. Thomas Hellmann, 1998. "The Allocation of Control Rights in Venture Capital Contracts," RAND Journal of Economics, The RAND Corporation, vol. 29(1), pages 57-76, Spring. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dirk Bergemann & Ulrich Hege & Liang Peng, 2008. "Venture Capital and Sequential Investments," Cowles Foundation Discussion Papers 1682, Cowles Foundation, Yale University, revised Nov 2008. [Downloadable!]
    Other versions:
  2. Dino Gerardi & Lucas Maestri, 2008. "A Principal-Agent Model of Sequential Testing," Cowles Foundation Discussion Papers 1680, Cowles Foundation, Yale University. [Downloadable!]
  3. Cripps, Martin & Keller, Godfrey & Rady, Sven, 2003. "Strategic Experimentation with Exponential Bandits," Discussion Papers in Economics 4, University of Munich, Department of Economics. [Downloadable!]
    Other versions:
  4. Bruno Strulovici, 2008. "Learning while voting: determinants of collective experimentation," Economics Papers 2008-W08, Economics Group, Nuffield College, University of Oxford. [Downloadable!]
  5. Josepa Miquel-Florensa, 2007. "Optimal Incentives in Dynamic Multiple Project Contracts," Working Papers 2007_2, York University, Department of Economics. [Downloadable!]
  6. Dirk Bergemann & Ulrich Hege, 2002. "The Value of Benchmarking," Cowles Foundation Discussion Papers 1379, Cowles Foundation, Yale University, revised Oct 2002. [Downloadable!]
    Other versions:
  7. Dino Gerardi & Lucas Maestri, 2009. "A Principal-Agent Model of Sequential Testing," Levine's Working Paper Archive 814577000000000076, David K. Levine. [Downloadable!]
  8. Georg Gebhardt, 2006. "A Soft Budget Constraint Explanation for the Venture Capital Cycle," Discussion Papers 173, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
  9. Sorensen, Morten, 2007. "Learning by Investing: Evidence from Venture Capital," SIFR Research Report Series 53, Institute for Financial Research. [Downloadable!]
  10. Boyan Jovanovic & Balàzs Szentes, 2007. "On the Return to Venture Capital," NBER Working Papers 12874, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Cripps, Martin W. & Keller, Godfrey & Rady, Sven, 2002. "Strategic Experimentation: The Case of Poisson Bandits," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  12. Levent Koçkesen & Saltuk Ozerturk, 2007. "Bargaining and exclusivity in a borrower–lender relationship," Review of Economic Design, Springer, vol. 11(1), pages 53-68, June. [Downloadable!] (restricted)
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