Financing Innovative Activity and the Endogeneity of Patenting

Abstract

Debt financing plays an important role in the funding of innovative firms, and patents have been increasingly used as collateral. We examine financing of innovative firms when future innovations are not verifiable and hence patenting, which creates a verifiable asset, cannot be contracted upon. We show that the endogeneity of the patenting decision creates an upper bound on the long-term payments that can be credibly promised to a lender. This introduces a unique inefficiency, which also affects the terms and feasibility of financing contracts.