Financing Innovative Activity and the Endogeneity of Patenting

It is common for lenders to require innovative firms to report all innovations and take actions, such as patenting, to protect their value. However, many future innovations are difficult to verify, making enforcement of such requirements difficult. This creates a tension for firms between protecting their innovations through patenting and creating assets that can be liquidated by a lender when not fully repaid. We show that the endogeneity of the patenting decision introduces an upper bound on the long-term payments that can be credibly promised to a lender, affecting the feasibility of obtaining financing and the terms of financial contracts. This paper was accepted by David Sraer, finance.