The Direct Effects of Equity Markets on Innovation

Abstract

In theory, financial markets promote innovation by selectively allocating capital to high-quality projects. In this paper, I show that secondary markets can inhibit innovation by permanently delaying option exercise and reducing a firm's ability to allocate capital efficiently. I find that short-term equity market declines cause pharmaceutical companies to abandon early-stage drug developments irrespective of drug quality or changes in a firm's stock price. I show that discount rate changes and financing constraints drive this behavior. My results demonstrate that even short-term market fluctuations can have long-term effects on pharmaceutical innovation and prevent potentially life-saving drugs from progressing to the market.