Using Innovator Competition to Limit Cost Inflation & Speed VC Investment

in Emerging Research, Faculty, Finance, News
November 8th, 2012

Enabling Investors to Capture More of the Upside of Innovation

Yrjo-KoskinenIn a new study titled “Innovation, Competition, and Investment Timing,” Yrjö Koskinen and Joril Maeland bring light to incentives that investors can deploy to limit cost inflation and speed investment time. Koskinen is a faculty member of the Boston University School of Management Finance Department, and Maeland of the NHH Norwegian School of Economics Department of Finance and Management Science.

In their new study, Koskinen and Maeland focus on the crucial role of competition in enabling investors to capture more of the upside of innovation. Using a real options framework, they build on past research about auction theory, optimal VC portfolio size, and investment triggers. They show that when innovators compete for funding, investors have a much better chance of gaining an accurate report of the innovators’ costs (effort and resources invested in the project’s development), thus avoiding falsely inflated prices and even enabling faster investments.

Motivating a Transparent Reporting of Costs

The authors explain the initial problem thus: “An innovator has an incentive to inflate the costs if he thinks he will be awarded the contract,” because by reporting a high output in time, effort, and resources for the project’s development, the innovator “can capture a difference between the declared and the true cost for himself.”

Conversely, if the investor has a choice of innovators vying for their contract and the number of innovators competing, the incentive to inflate costs diminishes dramatically, as competitors who report falsely high cost risk losing the contract to agents who more truthfully reveal a lower cost.

The result: the winner is only compensated for the actual costs, “enabling the investor to capture more of the upside of innovative activity.”

Speeding Time-to-Investment

In the traditional model of one investor evaluating one innovator, time-cost becomes another crucial factor: the higher the cost, the more the investment decision is delayed. Since the cost might be artificially inflated, the investor has to delay expensive investments as a way of giving the innovator proper incentives to reveal the real cost.

With the competition model, however, competition for funding reduces these informational costs, because innovators have reduced incentives to inflate costs. When the investor can choose the number of innovators freely, Koskinen and Maeland show, investment options are exercised so that there is never any delay.

Read the entire study “Innovation, Competition, and Investment Timing.”