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.
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- Spring '17