Survey_Hirsch_2006

Abstract

We consider a market of many venture capitalists (VCs) looking for profitable investment opportunities and some entrepreneurs (Es) with innovative ideas but without financial resources. Therefore, each E has to convince a VC to invest an amount of I in his project. As the market of VCs is competitive, Es have all the bargaining power ex ante. Moreover, we assume that the VCs and the Es are risk-neutral. Projects differ only in their inherent innovative value ? which is always observable by the contracting parties. Each project can be in three possible states (bad, medium, good) which result from a combination of the market conditions for the innovation and the quality of the E’s idea. The market conditions indicate whether the sales expectancy for the product is good or bad and the quality of the idea refers to the technological quality, i.e. the degree of feasibility. The project is of high quality with probability p or of low quality with probability (1 ? p), and the market conditions for the innovation areeither good with probability q or bad with probability (1 ? q). Below we will analyze the case of inexperienced markets where no information either about the technological quality of the project or about the market conditions before contracting exists. However, both contracting parties, the E and the VC, will learn the state of the project before exerting their effort levels. In a first step, we will derive the first-best solution as a benchmark. In a second step, we will determine the market solution before analyzing the influence of different public policy programs on contract design.