This document summarizes a model of financing risky research and development projects under conditions of asymmetric information. It examines how different types of informational imbalances impact equilibrium in venture capital markets. These asymmetries can involve a project's innate quality or the effort exerted by inventors and financiers. The model studies equilibrium screening and funding of projects when self-selection contracts are the only mechanism available, specifying investment levels and distribution of returns. Informational asymmetry about project quality and entrepreneur actions reduces inventor utility but increases effort and success rates, while asymmetry about financier actions further decreases inventor utility and leads to sub-optimal effort levels.

1. Financing Risky R&D Projects under Asymmetric Information
Noppe Lev
Abstract
We develop a model of competitive venture capital market for R&D projects financing
and analyze the conflicts of interest and contracting process in the presence of informational
asymmetry. We consider the effects of different types of informational asymmetries on
equilibrium in these markets. The informational asymmetries can be single and two-sided, and
can include the project’s innate quality, as well as the effort exerted by the inventor and
venture capitalist. Assuming away monitoring of inventors during the R&D process, we study
the equilibrium screening and funding of projects when the only instruments available are ex-
ante self-selection by inventors among funding contracts, which specify investment levels in
the project and ex-post distribution of project’s random returns between the inventor and the
financier. We find that investment levels can be optimal even when the project types are
unobservable to the venture capitalist. The informational asymmetry about both the quality of
project and entrepreneur actions reduces the utility of entrepreneurs with better projects but
increases their efforts and consequently the chances of project success. The informational
asymmetry about venture capitalist’s actions leads to the further decrease of entrepreneurial
utility and to an equilibrium level of effort by the venture capitalist which is lower than the
level that both parties prefer.