When less is more: Information and the financing of innovation

Abstract

This paper examines the impact of informational frictions when the entrepreneur anticipates having little or no bargaining power in negotiating with the financier and can select ex ante the innovation/venture he wants to develop. In this environment the entrepreneur faces a tradeoff between selecting an innovation that creates high value but one which only allows him to capture little or none of that value; or selecting a “pet-project” innovation that creates lower value but yields private benefits to him. In the baseline scenario, without contractual frictions, the financier is able to elicit first-best entrepreneurial effort, but cannot commit not to extract all innovation rents from the entrepreneur, leading the entrepreneur to select his favored but inefficient innovation. The key insight of the model is that the introduction of informational frictions like non-verifiability of effort or talent information asymmetry, while leading to reductions in effort (for a given innovation choice), may lead to more efficient (i.e. higher value) innovation choices ex ante, and indeed could generate a superior payoff to the financier and a greater total surplus from innovation. This yields several empirical implications, not least of which the potential motivation for financiers to commit to “opacity of information” when the resulting improvements in innovation selection dominate the impact of effort reduction.