The Financing of Innovation: Learning and Stopping
This paper considers the ﬁnancing of a research project under uncertainty about the time of completion and the probability of eventual success. The uncertainty about future success gradually diminishes with the arrival of addtional funding. The entrepreneur controls the funds and can divert them. We distinguish between relationship ﬁnancing, meaning that the entrepreneur’s allocation of the funds is observable, and arm’s length ﬁnancing, where it is unobservable. We ﬁnd that equilibrium funding stops altogether too early relative to the eﬀicient stopping time in both ﬁnancing modes. We characterize the optimal contracts and equilibrium funding decisions. The ﬁnancial constraints will typically become tighter over time under relationship ﬁnance, and looser under arm’s length ﬁnancing. The trade-oﬀ is that while relationship ﬁnancing may require smaller information rents, arm’s length ﬁnancing amounts to an implicit commitment to a ﬁnite funding horizon. The lack of such a commitment under relationship ﬁnancing implies that the sustainable release of funds eventually slows down. We obtain the surprising result that arm’s length contracts are preferable in a Pareto sense.
Bergemann, Dirk and Hege, Ulrich, "The Financing of Innovation: Learning and Stopping" (2001). Cowles Foundation Discussion Papers. 1545.