R&D Institutional Arrangements : Start-Up Ventures vs. Internal Lab

Why do some firms choose to undertake their Ramp;D by financing start-up companies, while other firms do it in their internal labs? We present a model where the choice of Ramp;D is driven by information asymmetries between the corporate venture capitalist and the idea owner on the quality of the project. In the complete information case, lower and higher quality projects are developed in the corporation lab, while projects in an intermediary range of qualities are developed as venture capital start-ups. Once we allow for asymmetric information on the quality of the project, higher quality projects are more likely to be developed by start-up firms, while low quality ones are exploited internally. The predictions of our model support the empirical findings of Jensen (1993). Also, two types of risk are identified, intrinsic quality risk and external shock risk. Riskier project quality and more difficult project monitoring make a project more likely to be developed as a new venture. Finally, the model is able to show why corporate lab scientists get most of their compensation as a fixed salary, while idea owner-entrepreneurs working for start-up companies have a profit sharing agreement