31 asymmetric information problems in the rd setting

3.1 Asymmetric-information problems
In the R&D setting, the asymmetric-information problem refers to the fact that an inventor or
entrepreneur frequently has better information about the nature of the contemplated innovation
project and the likelihood of its success than potential investors. Therefore the marketplace for financing
the development of innovative ideas looks like the “lemons” market modelled by Akerlof (1970). In his
model, the good (used) cars sells for a lower price in order to compensate the buyer for the possibility
that the car is a lemon. In this setting, the seller of potential returns to R&D or innovation offers a higher
return (lower price) to compensate the buyer for the possibility that the project is not as good as is
claimed. The lemons’ premium for R&D or innovation will be higher than that for ordinary investment
because investors have more difficulty distinguishing good projects from bad when the projects are
long-term R&D investments than when they are short-term or low-risk projects (Leland and Pyle 1977).
In the most extreme version of the lemons model, the market for R&D projects may disappear entirely
if the asymmetric-information problem is too great. Informal evidence suggests that some potential
innovators believe this to be the case in practice. Reducing information asymmetry via fuller disclosure
is of limited effectiveness in this arena, due to the ease of imitation of inventive ideas. Firms are reluctant
to reveal their innovative ideas to the marketplace and the fact that there could be a substantial cost
to revealing information to their competitors reduces the quality of the signal they can make about a
potential project (Bhattacharya and Ritter, 1983; Anton and Yao, 1998). Thus the implication of
asymmetric-information coupled with the costliness of mitigating the problem is that firms and inventors
will face a higher cost of external than internal capital for R&D due to the lemons’ premium. When the
level of R&D expenditure is an observable signal subject to external audit, as it is under current
accounting rules in several countries, we might expect that the lemons’ problem is somewhat mitigated,
but certainly not eliminated.
Asymmetric-information problems can sometimes be mitigated by reputations developed through
repeated interactions and this setting is no exception. There are several forms of reputation-building
observed. One of the important roles played by specialized venture capital (VC) funds is precisely to
supply informed monitoring of early stage technology start-ups, but experienced venture capitalists
will also have developed a reputation for honouring nondisclosure agreements that will enable them
to gather better information about projects being proposed. On the other side of the transaction,
serial entrepreneurs often face less difficulty in obtaining financing for new ventures, presumably
because they have developed a reputation in prior start-ups.