This chapter offers a broad context to understand innovation and characteristics of R&D investments. It gives an overview of different methods of financing R&D and then continues by providing a short summary of the literature related to financing constraints and R&D investments. This part concludes with a general model that shows the relationship of investments in innovation in companies with different organizations and reflects how innovations create value both for companies and the society.
The notion of innovation is associated with developing new and superior ways of doing things and put them into practice (Fagerberg et al., 2005). In fact, the first step of innovation is related to the creation of new information, which is known as invention (Arrow, 1962), while first attempts to put generated information into practice is innovation (Fagerberg et al., 2005). Invention and innovation are closely related to each other and sometimes it is difficult to separate them. As an example, in biotechnology, it is almost impossible to separate these two concepts. In other instances however, there is usually a significant time lag between these two processes (ibid.). Besides, the invention can take place anywhere, but innovations are mainly performed by firms (ibid.). Innovative firms, as a result, need to apply different kinds of resources, knowledge, and capabilities to be able to succeed in the long procedure of innovation (ibid.). This procedure has been treated as a “black box” for a long time since it was difficult to classify and collect data about firm’s innovations and activities that they undertake in this process (ibid.).
Schumpeter (1934) has developed a popular way to classify different types of innovations. According to this researcher, innovations are classified into five different categories, which are related to producing of new products, developing of new processes for production, discovering of new and better supplies, applying new marketing methods or finding new markets, and at last new ways for running and managing businesses (Schumpeter, first published 1983, Routledge 2017). However, only two first categories of this classification are generally used in economics (Fagerberg et al., 2005).
The mentioned classification has continuously brought up in different literature including Oslo Manual for definitions of innovation (Cruickshank, 2010). This manual firstly issued in 1992 by the Organization for Economic Co-operation and Development (OECD) to collect and apply data about innovations. This organization has the mission to improve the social and economic situation of people all around the world (OECD, 2018). It has also carried out a process of data collection in Europe about innovation activities of different companies through Community Innovation Survey (CIS) every four years since 1993 (OECD, 2005; Cruickshank, 2010, 18). Accordingly, by application of the same standards and equal surveys, OECD has made an evaluation of innovation possible at EU level (Cruickshank, 2010). Later with the second edition of the Oslo Manual in 2005, this organization developed new guidelines and innovation indicators to facilitate comparability of data and assist other countries in evaluating of their innovation activities (OECD, 2005).
Innovation and economic growth
Different studies have highlighted the important role of technological and organizational innovation in the acceleration of economic growth. In fact, changes in technology accompanied by organizational changes in different levels increase living standards and improve the quality of people’s lives in different regions (Verspagen, 2005). Nowadays, governments pay special attention to the subject of Innovation. As an example, after the global financial crisis, Chinese policy-makers decided to restructure the economy of their country through concentrating on scientific and technological innovations (Lin et al., 2017; Yanrui et al., 2017). Renewed interest of OECD in innovation and the extensive inclusion of this subject in its activities is another example of policy-makers’ attention to innovation at the international level (Cruickshank, 2010).
Ways in which innovation impact economic growth has also been the subject of debate through different economic theories and throughout the time. Economic models developed after the 1950s and 1960s assumed that technology is endogenous and there is a “linear relationship between the growth of labor productivity and the growth of capital per worker” (Verspagen, 2005, 490). Accordingly, these models reflected the fact that investments in human capital increase the productivity of entities and result in economic growth. Endogenous growth models had a different interpretation of the nature of knowledge and innovations, which was in contrast with neoclassical models. According to endogenous growth theory, knowledge is not a public good and knowledge spillover through different sectors and nations have a broad and positive impact and cause further developments (Verspagen, 2005).
Later in 1970, the relationship between technology and economic growth was confirmed one more time by the development of growth accounting models (Verspagen, 2005, 491). These models added “knowledge stock” to the traditional model of technical progress function, which was developed earlier and had only considered factors of labor and capital in the companies. They also suggest that knowledge positively affect productivity at different levels of accumulation, such as companies, industries, and countries. Studies related to these models developed the notion of R&D spillovers, which shows that knowledge produced by firms is not only beneficial for the producer of the knowledge but also benefit other firms in same or different sectors in different regions (Verspagen, 2005). Knowledge also plays an important role as a basis for generating more advanced knowledge in the future (Arrow, 1962). Lastly, the creation of new knowledge is an important prerequisite of innovations. In other words, “all the models assume that R&D is essentially a lottery in which the prize is a successful innovation” (Verspagen, 2005, 502). However, R&D has special characteristics that make its financing different from other sorts of investments. These characteristics are discussed in the next section.
Creation of new information or invention, which discussed by Arrow (1962), can be associated with R&D activities in the companies. Arrow (1962), exemplify the risky process of creating new information as a person, who has the capability to predict different states of nature. This person in the economy can be an entrepreneur that undertake research and have the knowledge of production and demand in a special field. Information, in this case, has an economic value, since it can give great advantages to the people that make effort to gain this knowledge. However, one can never predict outcomes from the inputs in this procedure. New information produced in the procedure of invention is also underestimated and not always rewarded properly, which reduces the quantity and quality of the research process.
Kerr & Nanda (2015), mention four distinctive characteristics for R&D performances. Firstly, this process is uncertain and uncertainty in this context is basically different from risk. In other words, in these kinds of investment, there is no chance to define any kind of probability about desired outcomes and sometimes potential results of the project are also unknown. Secondly, revenues from an innovation procedure are highly skewed and it is almost impossible to allocate the right amount of returns to the right periods with standard ways of evaluation. Thirdly, although investors and innovators are not fully aware of possible outcomes of R&D projects, the innovators still know more, but it is hard for them to calculate and declare required inputs into the innovation procedure (Kerr & Nanda, 2015). Moreover, in some cases, innovators are reluctant to reveal information about their R&D activities because of confidentiality considerations and they want to hinder information leak to their business counterparts (Lin et al., 2017). At last, with consideration of mentioned characteristics of R&D, agency costs are noticeably higher than the standard agency costs between investors and entrepreneurs (Kerr & Nanda, 2015).
High adjustment cost for R&D smoothing at the firm level is another important characteristic of R&D, which R&D intensive companies need to be aware of and make continuous adjustments to avoid unfavorable consequences of them (Kerr & Nanda, 2015; Sasidharan et al., 2015). These costs are related to salaries of educated employees and scientists, which their performances result in intangible assets for the company and generate profit for it in the future (Hall, 2002; Kerr & Nanda, 2015). Hall (2002, 36), estimated this cost to be about 50 percent of R&D expenditures. In other words, knowledge is rooted in human capital in R&D intensive companies. As a result, these companies need to be aware of the potential losses that generate from laying off or leaving their scientists and assign their R&D spending into appropriate intervals to avoid the high level of adjustment costs in later stages of their projects (Hall, 2002; Kerr & Nanda, 2015).
R&D investments are also more vulnerable to financial shocks resulted from economical instabilities and companies tend to decrease their R&D investments in the situation that their financial resources decrease to save up for their short-term expenditures. However, they increase these investments during economic booms (Brown et al., 2009; Fabrizio & Tsolmon, 2014; Sasidharan et al., 2015). Researchers have used the term of pro-cyclical for R&D investments. Accordingly, firms strategically time their R&D and innovation investments corresponding to the economic situation and market demands. This matter is more visible in financially constraint firms since they face more credit constraints in economic recessions (Fabrizio & Tsolmon, 2014).
Financing Innovation and R&D
Dividing a firm’s capital between debt and equity as external sources of financing to increase firm value has been the subject of debate through academic financing literature for a long time (Barclay & Smith, 2005). In fact, different firms have different needs for different kinds of financing, since they have distinctive cost structures, different sizes, and they operate in different markets (Kerr & Nanda, 2015, Mazzucato, 2013). Differences between companies accompanied by the fact that they select different sources of financing over their life cycle make their financing decisions diverse and complex (Brown et al., 2009; Mazzucato, 2013). Financing innovation and R&D, however, cannot be discussed effectively through traditional financing discussions, which only consider the optimal level of leverage of companies (Barclay & Smith, 2005). The reason for this difference is the special characteristics of R&D investments that make external financing more expensive for R&D intensive firms (O’Sullivan, 2005). In the following, academic papers related to financing innovation are reviewed to realize which financing methods provide innovation and R&D more appropriately.
Equity financing of R&D
Developed financial markets have an increasingly important role in urging the process of financing technological innovations and accelerate economic growth (Brown et al., 2009; Brown et al., 2012; Kerr & Nanda, 2015). In fact, common stocks solve the resource allocation problem and let different participants of financial markets diversify their portfolio and reduce their risk by obtaining a smaller amount of stocks from different companies to reach their optimal risk level (Arrow, 1962).
Brown et al. (2009), stated several important reasons for priority of equity financing over debt financing in R&D intensive firms. Firstly, there is no need for collaterals in this kind of investment and investors benefit from upside returns. The notion of upside return in this context is related to positive changes in stock prices, which increase stockholders’ equity (Klausner & Litvak, 2001). Secondly, additional equity does not increase problems of financial distresses that bring significant costs and negatively affect debtholders and non-financial stakeholders of companies (Brown et al., 2009). Financial distresses can also impair the availability of credits and increase costs of building relationships with different stakeholders of companies such as non-financial suppliers (Opler & Titman, 1994). For example, an extreme case of financial distress is bankruptcy, in which highly leveraged companies cannot meet their obligations towards their debtholders. Moreover, companies that file for bankruptcy need to bear indirect costs that originate from losing their market value. Even in less severe cases of financial distresses, companies with a higher amount of debt over equity are more likely to put off their valuable investment opportunities or decrease their investments in important projects such as R&D, training, and maintenance (Barclay & Smith, 2005).
At the same time, different researchers argue that market-based financial systems increase the productivity of innovative projects (Brown et al., 2009; Lehmann-Hasemeyer & Streb, 2016). They also believe that this way of financing decreases information asymmetries between investors and recipients since, in bank-based financial systems, only a few people including bank managers make the decision about financing innovative projects (Lehmann-Hasemeyer & Streb, 2016). However, these people might not have adequate information about these projects (ibid.). In fact, market-based financial systems apply widespread information about innovative projects and let everyone to make an investment according to their own prospects. (Lehmann-Hasemeyer & Streb, 2016).
Priority of equity financing over debt financing of R&D has also brought up in literature related to (IPOs) of companies. Through IPOs, companies that have grown appropriately and reached an acceptable size choose to go public for the first time to raise equity capital for their projects (Ritter & Welch, 2002). Lehmann-Hasemeyer & Streb (2016), as an example, consider 474 firms that reached for public equity in Germany in the period of 1892 to 1913 and confirm the important role of IPOs in financing innovations. To date, however, there has been little agreement about the reasons for success in innovative industries in the US and Germany before the First World War. Lehmann-Hasemeyer & Streb (2016), state that although the US and Germany were popular for different kinds of financial systems during the mentioned period, the financial systems of these two countries were more similar to each other than what stylized fact states. Fear & Kobrak (2010) also illustrate that despite major differences between regulations of the US and Germany, the banking system was playing an important intermediary role for stock markets in the US before the First World War. Another example in this matter is the study of Prianichnikov (2013), which considers innovative companies in Russia and realize that these companies are highly reliant on their IPOs since loans are expensive. Moreover, innovative companies are mainly formed by intangible assets and do not have sufficient collaterals. As a result, it is impossible for them to rely on debt financing for their innovative projects. Prianichnikov (2013) argues that a successful outcome of the IPOs of innovative companies is a leading cause for further investments of financers in later projects of these companies. Moreover, he states that IPOs have other benefits rather than raising credits for their companies. For example, they can increase the brand’s recognition, facilitate interaction with suppliers and banks and improve the efficiency of companies (Prianichnikov, 2013).
Debt financing of R&D
Results about the role of banks in financing innovations and R&D are contradictory in different studies. These differences are partially related to the country and time spans that different researches have been conducted. For example, the US has a developed market-based financial system and it has experienced significant growth in high-tech industries in the past century. However, Germany with rapid development in innovative industries is popular for its bank-based financial system (Lehmann-Hasemeyer & Streb, 2016). As stated by Kerr & Nanda (2015), banks have an increasing role in financing innovation within a wide range of industries. These researchers also suggest that public equity markets represent their own types of agency costs. On the other hand, according to several case studies in Germany, the banking sector has not always been a good alternative for funding young innovative companies and entrepreneurs (Lehmann-Hasemeyer & Streb, 2016). As an example, German universal banks have focused only on mature industries such as steel and iron, while they neglected new industries such as chemicals throughout the nineteenth century (ibid.).
Recent studies that conducted in Germany show a positive relationship between debt financing and R&D investments in companies. Fryges et al. (2015), as an example, suggests that there is a link between debt financing and R&D activities of newly established firms in this country. Besides, they prove that there is an interdependent linkage between R&D intensity and the proportion of loan financing in the financial structure of these companies. In other words, the higher share of loan financing can increase the R&D intensity of young firms, while higher R&D intensity can reflect better future growth perspectives and increase chances of firms to obtain more loans in the future (Fryges et al., 2015).
Studies that conducted in market-based financial systems, however, show that leverage in the capital structure of R&D intensive firms is typically lower than other firms (Hall, 2002; Barclay & Smith, 2005). Brown et al. (2009), specifies several reasons for undesirability of debt financing for R&D intensive companies, which are related to the uncertainty of projects, volatility of returns, lack of collateral and ambiguity of future performance and growth in these companies. It has been also argued that bank managers in the bank-based financial system may give priority to their own customers over innovative companies to protect them from new competitors (Lehmann-Hasemeyer & Streb, 2016). The controversy about the best way of financing innovation and financial structure of R&D intensive companies has stayed an open question (Fryges et al., 2015). Moreover, different studies show different financing patterns of companies, industries, and countries in different periods. Supply of financial resources by financial institutions is also dissimilar in various countries and over different time spans, which leads to dissimilar results of studies about financing structure of R&D intensive companies (O’Sullivan, 2005).
Table of contents :
2 Literature review
2.2 Innovation and economic growth
2.3 R&D characteristics
2.4 Financing Innovation and R&D
2.4.1 Equity financing of R&D
2.4.2 Debt financing of R&D
2.4.3 Financing R&D with internal resources
2.5 Background literature related to financing constraints
2.6 A framework for innovation requirements and results
3 Methodological considerations and data description
3.1 R&D regression as an empirical approach
3.2 Investment-cash flow sensitivity and its limitations
3.3 Description of the variables
3.4 Data source and sample characteristic
4.1 R&D investment in high-tech publicly listed firms
5.1 financing of R&D in small high-tech Swedish firms
5.1.1 General characteristics of R&D investments
5.1.2 R&D pro-cyclicality in aftermath of the global financial crisis
5.1.3 Firms age
5.2 Financing constraints and R&D investments
5.3 Role of firms and other institutions in reducing financing constraints
5.4 limitations of the study