Working Paper: NBER ID: w23831
Authors: Richard T. Thakor; Andrew W. Lo
Abstract: We develop a theory of optimal financing for R&D-intensive firms that uses their unique features—large capital outlays, long gestation periods, high upside, and low probabilities of R&D success—that explains three prominent stylized facts about these firms: their relatively low use of debt, large cash balances, and underinvestment in R&D. The model relies on the interaction of the unique features of R&D-intensive firms with three key frictions: adverse selection about R&D viability, asymmetric information about the upside potential of R&D, and moral hazard from risk shifting. We establish the optimal pecking order of securities with direct market financing. Using a tradeoff between tax benefits and the costs of risk shifting for debt, we establish conditions under which the firm uses an all-equity capital structure and firms raise enough financing to carry excess cash. A firm may use a limited amount of debt if it has pledgeable assets in place. However, market financing still leaves potentially valuable R&D investments unfunded. We then use a mechanism design approach to explore the potential of intermediated financing, with a binding precommitment by firm insiders to make costly ex post payouts. A mechanism consisting of put options can be used in combination with equity to eliminate underinvestment in R&D relative to the direct market financing outcome. This optimal intermediary-assisted mechanism consists of bilateral “insurance” contracts, with investors offering firms insurance against R&D failure and firms offering investors insurance against very high R&D payoffs not being realized.
Keywords: R&D financing; capital structure; market failure; innovation funding
JEL Codes: D82; D83; G31; G32; G34; O31; O32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| R&D financing (O32) | underinvestment in R&D (O39) |
| adverse selection + asymmetric information + moral hazard (D82) | underinvestment in R&D (O39) |
| risk shifting (H22) | optimal capital structure is all-equity (G32) |
| cost of debt due to risk shifting > value of tax shield associated with debt (G32) | optimal capital structure is all-equity (G32) |
| R&D-intensive firms raise all necessary financing upfront (D25) | avoid signaling R&D success later (O36) |
| intermediary-assisted financing mechanisms (O19) | prevent underinvestment (G31) |