Experimentation and project selection: screening and learning

Abstract

Firms must strike a delicate balance between the exploitation of well-known business models and the exploration of risky, untested approaches. In this paper, we study financial contracting between an investor and a firm with private information about its returns from exploration and exploitation. The investor-optimal mechanism offers contracts with different tolerance for failures to screen returns from exploitation, and with different exposure to the project's revenues to screen returns from exploration. We derive necessary and sufficient conditions for private information about returns from exploration to have zero value to the firm. When these conditions fail, private information about exploration may even decrease the firm's payoff. (C) 2016 Elsevier Inc. All rights reserved.