Financing Breakthroughs under Failure Risk

In a dynamic principal-agent model, the principal, financing the project, cannot observe project failure and the agent, developing the project, can hide or misreport failure. Time-decreasing rewards for failure and excessive rewards for success provide incentives for truthful disclosure of failure. As there is a tension between incentivizing disclosure of failure and project development, the optimal contract does not always incentivize disclosure of failure and consists of distinct financing stages, whereby financing becomes more performance-sensitive over time and incentives are backloaded. The optimal contract can be implemented by financing the project with a mixture of (convertible) debt and equity in multiple financing rounds.