Entrepreneurial Pressure and Innovation

Abstract:     
Ideas occur to managers that can replace existing technologies. Managers choose between contracts offered by an existing firm and a competitive venture capitalist. Implementing ideas within the existing firm has costs and advantages. Relying on existing assets makes implementation cheaper. But it also reduces contractual flexibility which is valuable in the presence of behavioral or informational frictions. To implement a new idea, the incumbent firm has to pay the manager an amount that depends on the venture capitalist offer. Venture capital affects the innovation policy of incumbents by changing both the threat of new ideas and their price. The value of an incumbent firm is endogenous and negatively related to the intensity of venture capital pressure. More innovative projects tend to be implemented in new ventures because of the importance of contractual flexibility. In equilibrium, the relation between innovation and the effciency of external capital markets is non-monotonic. A better venture capital market increases the innovation rate if the marginal innovation is done by the incumbent under pressure from outside.

Keywords: Entrepreneurship, Innovation, Venture Capital, Endogenous Growth

JEL Classifications: L2, M5, O3, O4, G2, G3

Working Paper Series