DP7750 | Incentives to Innovate and the Decision to Go Public or Private

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We model the impact of public and private ownership structures on firms' incentives to choose innovative projects. Innovation requires the exploration of new ideas with potential advantages but unknown probability of success. We show that it is optimal to go public when firms wish to exploit the current technology and to go private when firms wish to explore new ideas. This result follows from the fact that privately-held firms are less transparent to outside investors than publicly-held firms. In private firms, insiders can time the market by choosing an early exit strategy when they learn bad news. This option makes insiders more tolerant of failures and thus more inclined to choose innovative projects. In public firms, an early exit strategy is less valuable because there is less information asymmetry about cash flows. In such firms, prices of publicly-traded securities react quickly to good news, providing insiders with incentives to choose conventional but safer projects in order to cash in early when good news arrive. Extensions to the model allow us to incorporate other drivers of the decision to go public or private, such as liquidity and cost of capital. Our model rationalizes recent evidence linking private equity to innovation and creative destruction and also generates new predictions concerning the determinants of going public and going private decisions.