Financial structure matters for firm’s innovation

Innovation is paramount for firm growth and productivity. Well-functioning deep financial markets promote innovation by efficiently allocating capital to enterprises with promising projects (Levine, 2005). For example, risk-capital financing has fueled the growth of unicorns, such as Lazada, GoJek, Stripe, Telegram, VNG and Wildlife, and many other companies. Enterprises that fail to innovate, on the other hand, are at an increased risk of exiting the market. This allows for an efficient allocation of (often scarce) financial resources in the economy. In turn, this efficient allocation leads to higher productivity and, ultimately, growth.

A key policy question is how different sources of finance relate to firm innovation. In a new paper we explore this issue by testing how a firm’s financial sources correlate with the choice and the extent of innovating. The analysis is based on survey data from more than 17,000 firms across 104 countries over a decade It explores the cross-country variation in the relationship between financial structure and innovation, distinguishing between the development of invention and adoption, and diffusion of new technologies, products, and services.

Whether to collect funds internally or externally?

In principle, firms can use either internal funds (cash flows from retained profits or new capital injections) or external funding (credit or risk capital). Each source of finance has different characteristics that can help decrease market frictions that may result in the underinvestment in innovation projects. Internal financing is the main source of funding for most innovation projects (Czarnitzki and Hottenrott 2011). That’s the case especially for small and medium-sized enterprises (SMEs) and start-ups, which have a harder time accessing external sources because they don’t have an established reputation, a stable free cash flows, or the required collateral. As a result, innovative projects with high initial costs may be delayed, postponed, or abandoned due to a lack of external finance.

Funding innovation through external sources is also difficult for various reasons. First, the timeline from development to commercialization and the related cash flows from innovation are uncertain. Second, knowledge is non-rival, because development by one firm does not prevent the use by a competitor. This lack of full appropriability may lower the private rate of return to innovation, below the socially optimal level. Third, asymmetric information between the firm and prospective financiers (Hall and Lerner 2010) may make investors reluctant to invest.

Even though internal financing is said to be the main source of funding for most innovation projects, firm innovation - in terms of adoption and invention – appears to be higher for firms that collect funds through external sources  (Figure 1). This suggests that smaller, younger firms, with greater constraints to accessing external finance, may consequently have a harder time innovating and could benefit more from accessing a wider set of funding sources.

Figure 1: External financing is more prominent at innovative firms.

_{Source: Mare, de Nicola, and Miguel (2021)}

_{Note: This figure synthetizes how innovation is related to financing through internal funds. The Y axis reports the mean percent of fixed assets financed through internal funds. The blue bar denotes the mean percent of fixed assets financed through internal funds for firms with lower innovation (i.e., firms in the bottom 25 percent of the distribution of an innovation score). The red bars represent the percentage of fixed assets financed through internal funds for firms with higher innovation (i.e., in the 75 percent of the distribution of an innovation score). The gray bars characterize the differences between firms with lower and higher innovation where a negative value indicates that firms that innovate more finances with less internal funds. *** indicates statistical significance at the 1 percent level of the test of the difference in means.}

Bank financing or other external financing?

Since external funding may have a more positive effect on firm innovation, it is interesting to study the differential role of various types of external financing. We can distinguish bank financing, on the one hand, and funds obtained from non-bank financial intermediaries (NBFIs), on the other hand. As a residual category, we consider other sources of financing such as family and friends. Here we find that bank funding is strongly and positively associated with both the decision to innovate and the intensity of firm-level innovation . Weak evidence emerges regarding NBFI funding and the decision of innovating. Yet, we find a significant association between NBFI funding and a firm’s intensity of innovation; the relationship is even greater for NBFIs than banks. Other sources of funding, such as family and friends, help finance invention, but the effect on adoption non discernable.

We also explore how these effects change based on sector or country’s characteristics. First, we show that firms in less technologically oriented industrial sectors innovate more when using external finance. Second, we document a stronger and significant association between financing from banks and NBFI and the extent of innovation in countries with a high level of financial development.

How can policy improve access to innovation finance?

Our work shows that financial sources matter for the extent to which a firm innovates. Improving access to a variety of funding sources can therefore contribute to greater firm innovation, eventually fostering economic development.  To this end, policymakers may pursue a multipronged approach that seeks to:

1. Develop well-functioning capital markets. How? Based on reforms that were implemented in the East Asia and Pacific region, we see that increasing the investor base, improving financial market infrastructure (e.g. by investing in capital market data warehouse system), and enhancing investor protection are ways to improve the capital market performance (Abraham, Cortina, and Schmukler 2019).
2. Promote venture capital markets. How? By acting on three fronts (Cirera et al. 2021):
   • On the supply side, policymakers should promote clear bankruptcy rules and transparent accounting standards.
   • On the demand side, fostering an active entrepreneurial and innovation ecosystem is crucial.
   • Across the board, the institutional and regulatory framework should be strengthened. Credit guarantee schemes may also help leveraging existing bank-firm relations as suggested by the Korea Technology Finance Corporation (KOTEC) experience.

References

_{Abraham, Facundo, Juan J. Cortina, and Sergio L. Schmukler. 2019. “The Rise of Domestic
Capital Markets for Corporate Financing.” Policy Research Working Paper 8844, World Bank, Washington, DC.
Cirera, Xavier, Mason, Andrew D., de Nicola, Francesca, Kuriakose, Smita, Mare, Davide S., Tran, Trang Thu. 2021. “The Innovation Imperative for Developing East Asia.” World Bank East Asia and Pacific Regional Report. Washington, DC: World Bank. https://openknowledge.worldbank.org/handle/10986/35139 License: CC BY 3.0 IGO.        
Hall, Bronwyn H., and Josh Lerner. 2010. “The Financing of R&D and Innovation.” Pp. 609–39 in Handbook of the Economics of Innovation. Vol. 1. Elsevier B.V
Levine, Ross. 2005. “Finance and Growth: Theory and Evidence.” Pp. 865–934 in Handbook of Economic Growth. Vol. 1, edited by P. Aghion and S. N. Durlauf. Elsevier.
Mare, Davide S., de Nicola, Francesca., and Faruk Liriano, Miguel. 2021. “Financial Structure and Firm Innovation.” World Bank Policy Research Working Paper 9670, World Bank, Washington, DC}