How to Motivate Fundamental Innovation: Optimal Interactions Between Entrepreneurs, Venture Capitalists, and the Government

We analyze the roles of entrepreneurs, venture capitalists (VCs), and the government in financing fundamental innovations, defined as those with a positive social value net of development costs but often with negative net present values to innovating firms, for example, a vaccine against COVID-19. We first analyze the case where the entrepreneur, with or without VC financing, develops innovations. We then analyze government support of innovation and the government’s choice between subsidies and innovation prizes. We further analyze the optimal interactions between government and VC financing, showing that the government may optimally channel subsidies partially through VCs, thus rationalizing government-funded VCs. Overall, our paper provides a framework for the optimal choice of sectors and technologies to receive government support (e.g., subsidies included in the CHIPS and Science Act of 2022) and how any government support should be structured to best motivate innovation. This paper was accepted by Lin William Cong, finance. Funding: O. Bayar was supported by a summer research grant [COB INTRA grant] from the College of Business, University of Texas at San Antonio. T. J. Chemmanur acknowledges summer research support from Boston College and additional funding from a Hillenbrand Distinguished Fellowship. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2024.06188