Working Paper: CEPR ID: DP2763
Authors: Dirk Bergemann; Ulrich Hege
Abstract: 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 diminishes gradually with the arrival of additional 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.
Keywords: arms-length financing; innovation; learning; Markov perfect equilibrium; relationship financing; renegotiation; stopping time; venture capital
JEL Codes: D83; D92; G24; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| relationship financing (G32) | funding stopping too early (I22) |
| entrepreneur's discretion over funds (L26) | funding stopping too early (I22) |
| entrepreneur's discretion over funds (L26) | conflict of interest (G34) |
| conflict of interest (G34) | funding stopping too early (I22) |
| project's outlook becoming less promising (E66) | required compensation for entrepreneur increases (L26) |
| required compensation for entrepreneur increases (L26) | decrease in expected cash flow available for investors (G32) |
| decrease in expected cash flow available for investors (G32) | gradual reduction in funding (I22) |
| arms-length financing (G32) | adverse selection problem (D82) |
| unobservable actions (Y40) | investor's belief about project's likelihood of success is downgraded (G24) |
| adverse selection problem (D82) | divergence in beliefs about project's viability (O22) |
| arms-length contracts (L14) | higher project value (O22) |