Optimal financing of highly innovative projects under double moral hazard

Gino Loyola and Yolanda Portilla

Journal of Corporate Finance, 2024, vol. 89, issue C

Abstract: A model is proposed for analyzing the financing of highly innovative projects undertaken by an investor and an entrepreneur as partners. It is shown that the optimal contract rewards the entrepreneur for success and failure but penalizes him for moderate returns. This theoretical scheme can be implemented by a hybrid financial structure that combines inside and outside equity and that is subsequently balanced by means of a reassignment mechanism contingent upon the project’s returns. Two settings are compared, one in which either of the partners innovates but not both (single moral hazard) and another in which both partners do (double moral hazard). We show that which setting is best depends on the degree of technological dependence between the partners’ innovation processes. This may explain the coexistence in practice of different financing and partnership arrangements.

Keywords: Reward for failure; Optimal financial contract; Entrepreneurship financing; Non-monotone likelihood ratio property (search for similar items in EconPapers)
JEL-codes: D86 G11 G20 G30 J33 M52 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:corfin:v:89:y:2024:i:c:s0929119924001469

DOI: 10.1016/j.jcorpfin.2024.102684

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