Asset Specificity,R&D Financing,And The Signalling Properties of The Firm's Financial Structure

Equity financing is the optimal strategy for innovating firms, which can use their financial structure as a signalling device to attract outside investors. This situation is likely to arise when the firm undertakes a specific purpose R&D project aimed at developing a certain product innovation. Typically, innovations of this kind draw on the firm's cumulative. idiosyncratic knowledge base and, accordingly, the innovation process involves an high degree of asset specificity. Under such circumstances, the terms of debt financing will be adjusted adversely, and equity financing will represent the most economically efficient solution.

These arguments are developed in standard static principal-agent models dealing with New Technology Based Firms and publicly held large firms undertaking an aggressive R&D strategy. In the case of NTBFs, two kinds of optimal venture capital contracts are considered, which render the sharing rules independent (a) of the agent's action and (b) of both the agent's action and the specific assets involved in the transaction. Regarding innovating large firms, it is argued that in this case, too, equity represents the optimal financing strategy, and that top executives use their equity share to signal the firm's expected return stream and value to outside investors.