Financing Innovation with Future Equity

This article studies future equity financing in a continuous-time principal-agent setup whereby career concerns generate moral hazard tension. Our framework admits precise closed-form expressions. The higher firm value leading up to conversion, the fewer equity investors attain and the less risk the entrepreneur takes. We implement the contract using a convertible note with a valuation cap, that if set too high, developing innovation becomes suboptimal. Lastly, we introduce the implied probability of success: a novel measure allowing for risk comparison across different innovative technologies. We demonstrate its use to empirically estimate investors' skill and correct selection bias in realized returns.