Adverse Selection And Financing Of Innovation: Is There Need For R&D Subsidies

The authors 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. They 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.