Real Options as Signals: Insights from Biotechnology, 1973-1998

Entrepreneurship is a three part race: finding an opportunity, convincing others to invest, and then executing the opportunity. The 2nd race is especially challenging for knowledge intensive firms, because they possess valuable information that investors do not have, but must be careful revealing the information. One way to do so is through Private placements, which differ from public equity in four key ways. First, only accredited investors (“smart money”) may make the investment. 2nd they are largely illiquid for 30 days-two years. 3rd investors may conduct a due diligence investigation. Finally, they can demand covenants for their investment.Very importantly, while the information in a private placement is not revealed, the fact that an accredited investor has made an investment is revealed, and other investors can use that information to assess the quality of the focal firm. For nascent firms, it benefits them to do a private placement to a better known investor, even at a discount, as it increases the likelihood of their attracting future financing from other investors. Investor experience, and milestones enhance this effect.