Optimal Financing for R&D-Intensive Firms

62 Pages Posted: 18 Sep 2017

See all articles by Richard T. Thakor

Richard T. Thakor

University of Minnesota - Carlson School of Management

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Multiple version iconThere are 2 versions of this paper

Date Written: September 2017

Abstract

We develop a theory of optimal financing for R&D-intensive firms that uses their unique features—large capital outlays, long gestation periods, high upside, and low probabilities of R&D success—that explains three prominent stylized facts about these firms: their relatively low use of debt, large cash balances, and underinvestment in R&D. The model relies on the interaction of the unique features of R&D-intensive firms with three key frictions: adverse selection about R&D viability, asymmetric information about the upside potential of R&D, and moral hazard from risk shifting. We establish the optimal pecking order of securities with direct market financing. Using a tradeoff between tax benefits and the costs of risk shifting for debt, we establish conditions under which the firm uses an all-equity capital structure and firms raise enough financing to carry excess cash. A firm may use a limited amount of debt if it has pledgeable assets in place. However, market financing still leaves potentially valuable R&D investments unfunded. We then use a mechanism design approach to explore the potential of intermediated financing, with a binding precommitment by firm insiders to make costly ex post payouts. A mechanism consisting of put options can be used in combination with equity to eliminate underinvestment in R&D relative to the direct market financing outcome. This optimal intermediary-assisted mechanism consists of bilateral “insurance” contracts, with investors offering firms insurance against R&D failure and firms offering investors insurance against very high R&D payoffs not being realized.

Suggested Citation

Thakor, Richard T. and Lo, Andrew W., Optimal Financing for R&D-Intensive Firms (September 2017). NBER Working Paper No. w23831. Available at SSRN: https://ssrn.com/abstract=3038659

Richard T. Thakor (Contact Author)

University of Minnesota - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)

HOME PAGE: http://web.mit.edu/alo/www

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Stata Center
Cambridge, MA 02142
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
12
Abstract Views
203
PlumX Metrics