How to Motivate Fundamental Innovation: Optimal Interactions between Entrepreneurs, Venture Capitalists, and the Government

Abstract

We analyze the roles of entrepreneurs, venture capitalists (VCs), and the government in financing fundamental innovations, defined as those with positive social value net of development costs, but often with negative net present values to innovating firms: e.g., a vaccine against COVID-19. We first analyze the case where the entrepreneur, with or without VC financing, develops innovations. We then analyze government support of innovation and the government's choice between subsidies and innovation prizes. We further analyze the optimal interactions between government and VC financing, showing that the government may optimally channel subsidies partially through VCs, thus rationalizing government-funded VCs. Overall, our paper provides a framework for the optimal choice of sectors and technologies to receive government support (e.g., subsidies included in the CHIPS and Science Act of 2022) and how any government support should be structured to best motivate innovation.

Keywords: Financing of innovations, Fundamental innovation, Venture capital financing, Innovation and the going public decision, Government subsidies, Innovation prizes

JEL Classification: G24, G32, G38, O31, O32