Production, Process Investment and the Survival of Debt Financed Startup Firms

Whether to invest in process development that can reduce the unit cost and thereby raise future profits or to conserve cash and reduce the likelihood of bankruptcy is a key concern faced by many startups firms that have taken on debt. We explore this concern by examining the production quantity and cost-reducing R&D investment decisions in a two period model. A startup firm must make a minimum level of profits at the end of the first period to survive and continue operating in the second period. We show that under a base case, with deterministic demand, such a startup should produce the monopoly quantity and use an invest-all-or-nothing investment policy. However, under stochastic demand and allied survival constraint, the optimal investment policy does not necessarily have an all-or-nothing character. We establish conditions for creating hedges through either aggressive or conservative investment alternatives. If the startup makes a “conservative” investment decision, it sacrifices some first period expected profits to increase its survival chances and chooses an optimal quantity less than the monopoly quantity. Further, if the startup decides to invest “aggressively”, then it produces more than the monopoly quantity to cover the higher bankruptcy risk due to such aggressive investment.