Incentives to innovate and the decision to go public or private

We model the impact of public and private ownership structures on firms’incentives to invest in innovative projects. We show that it is optimal to go public when exploiting existing ideas and optimal to go private when exploring new ideas. This result derives from the fact that private firms are less transparent to outside investors than are public firms. In private firms, insiders can time the market by choosing an early exit strategy if they receive bad news. This option makes insiders more tolerant of failures and thus more inclined to invest in innovative projects. In contrast, the prices of publicly traded securities react quickly to good news, providing insiders with incentives to choose conventional projects and cash in early. (JEL G24, G32, O32) We introduce a model in which the form of equity financing—either public or private—affects managers ’ incentives to innovate. Our main contribution is to show that private ownership creates incentives for innovation, whereas public ownership disincentivizes innovation. As we allow for an endogenous choice of ownership structure, the model also provides, to the best of our knowledge, a novel explanation for the decision to go public or private. We find that thi