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The Financing of Innovation: Learning and Stopping

  • Bergemann, Dirk
  • Hege, Ulrich

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 diminishes gradually 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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2763.

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Date of creation: Apr 2001
Date of revision:
Handle: RePEc:cpr:ceprdp:2763
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  1. Kaplan, Steven & Strömberg, Per Johan, 2000. "Financial Contracting Theory Meets The Real World: An Empirical Analysis Of Venture Capital Contracts," CEPR Discussion Papers 2421, C.E.P.R. Discussion Papers.
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  13. Joseph Farrell and Eric Maskin., 1987. "Renegotiation in Repeated Games," Economics Working Papers 8759, University of California at Berkeley.
  14. Peter M. DeMarzo & Michael J. Fishman, 2007. "Optimal Long-Term Financial Contracting," Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 2079-2128, November.
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  28. Steven N. Kaplan & Per Str�mberg, 2003. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," Review of Economic Studies, Oxford University Press, vol. 70(2), pages 281-315.
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