Venture Capitalists, Asymmetric Information and Ownership in the Innovation Process

Abstract:     
This paper constructs a model where entrepreneurial innovations are sold into oligopolistic industries and where adverse selection problems between entrepreneurs, venture capitalists and incumbents are present. We first show that aggressive development of a basic innovation by better informed venture-backed firms is used as a signaling device to enhance the sale price of the innovation. We then show that incumbents can undertake early, preemptive, acquisitions to prevent such signaling driven overinvestment, despite the risk of buying a non-productive innovation. Therefore, to exist in equilibrium, venture capitalists must be sufficiently more efficient in selecting innovation projects, otherwise preemptive acquisitions will take place.

Keywords: venture-backed firm, innovation, signaling, overinvestment, interim development, M&A

JEL Classifications: C7, D21, D82, G24, L2, M13, O3

Working Paper Series