The Financing of Innovation: Learning and Stopping

• Published in: The Rand journal of economics Vol. 36; no. 4; pp. 719 - 752
• Main Authors: Bergemann, Dirk, Hege, Ulrich
• Format: Journal Article
• Language: English
• Published: Santa Monica RAND 01-12-2005; The RAND Corporation; Rand Corporation; Wiley
• Series: RAND Journal of Economics
• Subjects: Academic profession; Bargaining power; Business administration; Difference equations; domain_shs.gestion.fin; Economic models; Entrepreneurs; Finance; Financial investments; Funding; Humanities and Social Sciences; Innovation diffusion; Investment funds; Investors; Project finance; R&D; Research & development; Research and development; Research centres; Research coordination; Research projects; Start up firms; Studies; Tradeoff analysis; Uncertainty; Unobservables; Venture capital; Learning and stopping; Financing of innovation
• ISSN: 0741-6261; 1756-2171

We consider 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 tradeoff in the choice of financing modes is between lack of commitment with relationship financing and information rents with arm's-length financing.