Innovation and Financial Markets

In this paper, we study the dynamics of innovation financing as a new industry emerges. Specifically, in an environment where the profitability of an industry is uncertain, we consider the dynamics of the adoption of innovations/projects and the relative shares of bank and venture capital financing out of total innovation funding in the sector. In our setup, the implementation of innovations requires an initial fixed investment. Funding may be provided by one of the two financial institutions we consider: banks or venture capitalists. We assume that venture capitalists add value to the project relative to the bank. The literature identifies several sources for this operational advantage of venture capitalists relative to other financial institutions; it may stem from better screening ability, better monitoring ability, or greater knowledge of the human and physical capital requirements necessary for project implementation. Banks have a countervailing advantage, from the point of view of entrepreneurs, in that the banking sector is more competitive than venture capital. In fact, while entrepreneurs are able to retain all the surplus from the project when financed by a bank, if financing is provided by a venture capitalist they only retain the fraction ï ¡ïƒŽ(0,1) of the project’s value. Each period, an innovator generates an innovation. The return from its implementation depends on the innovator’s publicly observable ability, the true – but unknown – profitability of the industry/sector, the type of financing institution that finances the innovation, and on a random component. As mentioned above, venture capitalists add value to the project’s expected return as compared to banks. The entrepreneur’s ability, the industry’s profitability, and the random luck component are normally distributed. As entrepreneurs adopt innovations, banks and venture capitalists alike observe the resulting returns and update their priors concerning the industry value in a Bayesian way. For a given value of the profitability of the industry (either an initial condition or the result of learning from previous adoption), there is a threshold ability level such that, for ability under this threshold, no project is financed. The probability that a project does not receive financing is the probability that ability fall under this threshold. The ability threshold that triggers bank financing exceeds the previous threshold. Therefore, there is an interval for entrepreneurial ability such that financing is only provided by venture capitalists. The probability of venture capital financing is then the probability that ability fall in between these two thresholds. For ability above the bank-financing threshold, entrepreneurs are exclusively financed by banks (as they get a higher expected return out of the project through bank financing). Our main results concern the relationship between the time path of the industry’s profitability and the probability that a project receives financing, as well as the relative shares of bank versus venture capital financing conditional on financing being provided. We show that (i) The probability that financing takes place is increasing in the industry’s value; further, (ii) Conditional on financing taking place, the share of venture capital financing to total financing is decreasing in the industry’s profitability. A number of testable implications follow from these results. First, in industries where the true underlying profitability is high, we expect to see the share of venture capital decline over time as financial institutions learn its intrinsic value. Second, an exogenous event – such as a dot-com bust – that leads to a downward adjustment of the prior concerning industry value, should be followed by a decrease in the probability of a project receiving financing and, conditional on financing taking place, to an increase in the relative share of venture capital financing.