The Financing of Innovation: Learning and Stopping

Abstract

We consider the financing of a research projectunder uncertainty about the time of completion and the probability of eventualsuccess. We distinguish between two financing modes, namely relationshipfinancing, where the allocation decision of the entrepreneur is observable, andarm's-length financing, where it is unobservable. We find that equilibrium funding stops altogether too early relative to theefficient stopping time in both financing modes. The rate at which funding isreleased becomes tighter over time under relationship financing, and looserunder arm's-length financing. The tradeoff in the choice of financing modes isbetween lack of commitment with relationship financing and information rentswith arm's-length financing. (Publication abstract)

Keywords: R&D, Information asymmetry, Uncertainty, Commitment, Interpersonal relations, Angel investors, Conflict management, Financing, Rates of return