Innovations and Venture Capital

This paper develops a theory why innovation often takes place in new rms that depend overproportionally on external nance usually supplied by specialist intermediaries called venture capitalists. It is argued that innovative projects are characterized by two features: uncertainty that is resolved through a learning by doing process and private bene ts for the entrepreneur from running the project. If the e ort choice of the entrepreneur is observable to the investor but not contractable the entrepreneur has an incentive not to supply e ort to jam the learning process and to prevent the investor from terminating the project. If the investor cannot observe the e ort choice his decision must be independent from the actual e ort choice and the agency problem can be solved. While banks and internal capital markets su er from this soft budget constraint problem venture capital funds are immune to it. Because they only have a limited amount of capital new, uninformed investors have to be found to continue the project. This hardens the budget constraint.