The Financing of Innovation: Learning and Stopping
CFDP Revision Date
This paper considers the ﬁnancing of a research project under uncertainty about the time of completion and the probability of eventual success. We distinguish between two ﬁnancing modes, namely relationship ﬁnancing, where the allocation decision of the entrepreneur 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. The rate at which funding is released becomes tighter over time under relationship ﬁnancing, and looser under arm’s length ﬁnancing. The trade-oﬀ in the choice of ﬁnancing modes is between lack of commitment with relationship ﬁnancing and information rents with arm’s length ﬁnancing.
Bergemann, Dirk and Hege, Ulrich, "The Financing of Innovation: Learning and Stopping" (2001). Cowles Foundation Discussion Papers. 1546.