Innovation, Capital Structure, and the Boundaries of the Firm∗

We study how interactions between financing and investment decisions can shape firm boundaries in innovative markets. In particular, we model innovative projects as growth options and ask whether they are best operated inside large incumbent firms (Integration) or in separate, specialized firms (Non-Integration). Starting from a standard theoretical framework, in which value-maximizing corporate investment and financing decisions are jointly determined, we show that Integration best protects assets in place value, while Non-Integration best protects the value of the innovation option and maximizes financial flexibility. These forces drive different organizational equilibria depending on firm and product market characteristics. We also show that alliances organized as licensing agreements or revenue sharing contracts sometimes better balance the different sources of value, and thus may dominate more traditional forms of organization. JEL Classification Numbers: G13, G31, G32, G33.