Financing Innovation with Unobserved Progress

Zehao Hu ()
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Zehao Hu: Department of Economics, University of Pennsylvania

PIER Working Paper Archive from Penn Institute for Economic Research, Department of Economics, University of Pennsylvania

Abstract: This paper studies the problem of incentivizing an agent in an innovation project when the progress of innovation is known only to the agent. I assume the success of innovation requires an intermediate breakthrough and a final breakthrough, with only the latter being observed by the principal. Two properties of optimal contracts are identified. First, conditional on the total level of financing, optimal contracts induce efficient actions from the agent. Second, the reward for success to the agent is in general non-monotone in success time and later success may be rewarded more. The latter property is consistent with the use of time-vested equity as part of compensation schemes for entrepreneurs. I then extend the model by introducing randomly arriving buyers and apply it to study the financing of startup firms with opportunities to be acquired. I show that the potential acquisition increases the cost of providing incentives. Since an agent with low level of progress is “bailed out†when an offer is made to acquire firms with both high and low levels of progress, the agent has more incentive to shirk. In response, the principal reduces the likelihood that the firm with high level of progress is sold. Moreover, the total financing provided by the principal is less compared to the environment without buyers.

Keywords: Contract Theory; Dynamic Agency; Multistage Innovation; Asymmetric Information; Venture Capital; Acquisition (search for similar items in EconPapers)
JEL-codes: C73 D82 G32 (search for similar items in EconPapers)
Pages: 60 pages
Date: 2014-11-26
New Economics Papers: this item is included in nep-ino, nep-knm and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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