Adverse selection and financing of innovation: is there a need for R&D subsidies?
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We study the interaction of private and public funding of innovative projects in the presence of adverse-selection based financing constraints. Government programs allocating direct subsidies are based on ex ante screening of the subsidy applications. This selection scheme may yield valuable information to market-based financiers. We find that under certain conditions, public R&D subsidies can reduce the financing constraints of technology-based entrepreneurial firms. First, the subsidy itself reduces the capital costs related to the innovation projects by reducing the amount of market-based capital required. Second, the observation that an entrepreneur has received a subsidy for an innovation project provides an informative signal to the market-based financiers. We also find that public screening works more efficiently if it is accompanied with subsidy allocation.
KeywordsAdverse selection Innovation finance Financial constraints R&D subsidies Certification
JEL ClassificationD82 G28 H20 O30 O38
We thank four anonymous referees for extensive comments. We also thank Ari Hyytinen, Saul Lach, Mikko Leppämäki, Pere Ortín Ángel, Petri Rouvinen, Javier Suarez, Otto Toivanen, John Van Reenen, Timo Vesala, Juuso Välimäki and seminar audiences at the University of Jyväskylä, conference on the Dynamics of SBEFs in Sestri Levante, the 34th EARIE conference in Sevilla, Bank of Finland and Helsinki School of Economics for comments. We gratefully acknowledge financial support from Tekes. Tanayama also thankfully acknowledges funding from the Foundation of Finnish Cooperative Banks.
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