Optimal Project Rejection and New Firm Start-Ups

Abstract

Entrants are typically found to be more innovative than incumbent firms. Furthermore, these innovative ideas often originate with established firms in the industry. Therefore, the established firm and the start-up firm seem to select different types of projects. We claim that this is the consequence of their optimal project allocation mechanism, which depends on their comparative advantage. The start-up firm may seem more 'innovative' than the established firm may because the comparative advantage of the start-up firm is to commercialize 'innovative' projects, i.e. projects that do not fit with the established firms' existing assets. Our model integrates various facts found in the industrial organization literature about the entry rate, firm focus, firm growth, industry growth and innovation. We also obtain some counter-intuitive results such that a reduction in the cost of start-ups may actually slow down start-ups and that the firm may voluntarily give away the property rights to the inventions discovered within the firm.

Keywords: Real option, project selection, new firm start-ups

JEL Classification: D21, G31, L11