Intermediation and Innovation

Peter MacKay (HKUST)
Thursday, July 10, 2014 - 2:00pm
Spandauer Straße 1, Room 220

We propose a model of research and development (“innovation”) under costly external finance. In the research stage, the entrepreneur draws on human capital to raise the base productivity of an endowed project before seeking funds from uninformed investors. True base productivity (and the implied optimal research effort) can be conveyed to investors by incurring a fixed cost. In the development stage, the entrepreneur allocates scarce financial capital between the base project and its risky enhancement. Alternatively, the entrepreneur may use an intermediary (“headquarters”, HQ) to approach capital markets indirectly at a proportional cost but with uncertain outcome because HQ may fail to discover (and communicate) true base productivity. Thus, the success of HQ-mediated funding depends on the intensity of HQ’s costly investigative activity. Realized surplus in each case (direct or indirect financing) can either be used to repay investors on fixed terms – a debt-like contract – or shared with investors – an equity like contract. We derive the optimal innovation levels, investigative intensity, and surplus sharing rule under each type of organizational form (direct or indirect financing) and financial contract (debt or equity).