Optimal Financing Design for Drug Development Firms

Abstract

We examine optimal financing design for R&D-intensive firms developing new drugs. When firms raise external financing using equity, they underinvest in R&D. But when the set of contracts is augmented to include more general (non-linear) payoff schemes, options combined with equity financing, this underinvestment is reduced. We then use a mechanism design approach and show that such non-linear schemes can attenuate R&D underinvestment by using a novel financing design that combines equity with put options to provide bilateral insurance to firms and investors. Investors insure firms against R&D failure and firms insure investors against high R&D payoffs not being realized. Interviews with industry experts indicate both the attractiveness and feasibility of the new financing design.

Keywords: R&D Investments, Innovation, Drug Development, Biotechnology, Capital Structure, Mechanism Design

JEL Classification: D82, D83, G31, G32, G34, O31, O32