Optimal Financing for R&D-Intensive Firms

62 Pages Posted: 18 Sep 2017 Last revised: 12 Aug 2024

See all articles by Richard T. Thakor

Richard T. Thakor

University of Minnesota - Carlson School of Management; Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

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

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street, E62-618
Cambridge, MA 02142
United States

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( 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

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
84
Abstract Views
903
Rank
137,504
PlumX Metrics