Strategic Alliances, Externalities, and Financial Constraints

This paper models a financially constrained entrepreneur and a deep-pocket incumbent developing an innovative product through a strategic alliance. We find that i) the financial constraints of the entrepreneur can be tightened by an increase in his endowment or a reduction in agency conflicts, which contrasts with traditional corporate finance theories; ii) the main agency conflict in alliances is the free-riding problem between the two collaborators, and a third party — an outside investor — can be introduced to address this problem; and iii) the incentive-compatible financial claims of alliances include debt, equity, warrants, convertible debt, and preferred equity, which are consistent with empirical observations.