On a research and development financing contract.

Author:Ayayi, Ayi Gavriel

    Continual innovation is a key determinant for long-term sustained growth. However small firms and particularly high-tech small and medium size enterprises (HTSME) generally lack the necessary assets base and find raising external financing problematic.

    Issuing shares increases equity dilution, whereas debt financing is only suitable for projects which lead up redeployable assets. Furthermore, since external financing entails the disclosure of technological information to potential investors, HTSME face a dilemma: either complete disclosure (that almost inevitably leads to high overflow effects) in order to obtain the appropriate financing costs that best reflect the value of their innovation or reluctance to reveal relevant information leads to higher financing costs.

    In this paper I look at a financing contract that HTSME could use when they suffer from financing shortage. The intended contributions of the paper are twofold. First, to design a financing contract that may provide HTSME the ability to float R&D outlay as a distinct project, while maintaining the option to gain ultimate control over successfully developed products and technologies. A second intended contribution is the minimization of the opportunistic behaviours entailed either by asymmetric information and/or inadequate understanding of the motives and the health of the HTSME.

    The paper draws upon the financial contracting and agency problem literature. Takhor (1989), Harris and Raviv (1991) and Allen and Winton (1994) provide good surveys of these strands of the literature. The common feature of the above literature is that it views a firm performance as arising from the optimal design of contracts.

    There are three additional sections. Section II presents the R&D financing contract and organizational design. Section III presents the model. Section IV concludes.


    When a firm wants to convince investors to invest in a new project, it must not only decide upon what financial instruments it will use but also upon its governance structure. The traditional approach which incorporates the project as part of the firm and finances it by selling new securities is often inefficient because it forces the financiers to bear not only the related risk of the project but also the firm's total risk. Moreover, this approach provides the opportunity to divert the funds raised to finance other risky investments, thus increasing the financier's risk exposure. Such moral hazard in assets substitution leads the investors to bear additional costs. Since investors are aware of this fact, they will respond by increasing the financing cost. To reduce this cost, the project could be incorporated as a new company legally separated from the rest of the firm.

    This partnership, as an alternative to the more traditional in-house (debt and equity) funding, has three advantages. First, it minimizes the HTSME equity dilution because the resulting equity price is greater than the one that results from the traditional approach. Second, it allows the investors to be paid directly from the new venture cash flows before they can be claimed by the parent financiers. Third, it allows HTSME to develop their production and marketing perspectives instead of acting as research laboratories of wealthy companies.

    Named Research and Development Financing Organization (RDFO), this incorporation consists in finding a way to raise and spend R&D funds. First without sacrifying the property rights of the R&D results, second without showing annual losses in the accounts for research Costs, and third to channel the funds from the investors to the HTSME to pay the R&D expenditures. In spite of these upsides, RDFO also has drawbacks. First, it may be a way for the HTSME to share or to shift the R&D risk with RDFO's investors. Second, it may exacerbate incentive problems by increase...

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