Financial Dependence and Innovation

The following post comes to us from Viral Acharya, Professor of Finance at NYU, and Zhaoxia Xu of the Department of Finance and Risk Engineering at NYU.

While innovation is crucial for businesses to gain strategic advantage over competitors, financing innovation tends to be difficult because of uncertainty and information asymmetry associated with innovative activities (Hall and Lerner (2010)). Firms with innovative opportunities often lack capital. Stock markets can provide various benefits as a source of external capital by reducing asymmetric information, lowering the cost of capital, as well as enabling innovation in firms (Rajan (2012)). Given the increasing dependence of young firms on public equity to finance their R&D (Brown et al. (2009)), understanding the relation between innovation and a firm’s financial dependence is a vital but under-explored research question. In our paper, Financial Dependence and Innovation: The Case of Public versus Private Firms, which was recently made publicly available on SSRN, we fill this gap in the literature by investigating how innovation depends on the access to stock market financing and the need for external capital.

We use a firm’s public listing status to capture the access to stock markets and investigate its impact on innovation. While firms can gain an access to a large pool of low cost capital by trading on exchanges, they also face the pressure from myopic investors to generate short-term profits (Stein (1989)). Therefore, we expect that the effect of public listing on innovation will depend on the trade-off between the benefits and costs associated with listing on stock markets, which vary across firms with different degrees of dependence on external finance.

By analyzing the innovation activities of a large sample of private and public firms between 1994 and 2004, we observe that public firms in external finance dependent (EFD) industries on average have patents of higher quantity, quality, and novelty than their private counterparts, but not public firms in internal finance dependent (IFD) industries. Industries with internal cash flows less (more) than their investments are considered as EFD (IFD) industries.

To understand the differential effects of public listing on innovation of firms in EFD and IFD industries, we explore four factors that may affect the cost-benefit trade-offs associated with being public. First, public listing could relax the financial constraints faced by firms in EFD industries. Consistent with this financing view, we find that firms in more innovation intensive industries with more dependence on external capital are more likely to obtain access to stock market financing.

The observed difference in innovation may also be driven by the variation in firms’ ability to use R&D to generate patents. To explore this second possibility, we test whether public and private firms differ in their innovation efficiency measured as the natural logarithm of one plus the number of patents per dollar R&D investment. We find a higher innovation efficiency for public firms in industries dependent on external finance, but no significant difference for private and public firms in IFD industries.

Third, a part of the literature has argued that public firms are prone to agency problems given the separation of ownership and control. Under the pressure of myopic investors, managers have incentives to pursue short-term performance (Stein (1989), Bolton et al. (2006)). In light of the short-termism model, we investigate public firms’ real earnings management activities in relation to their degree of external finance dependence and innovation. We find that more innovative public firms in EFD industries engage less in earnings management through their alteration of their real activities. To the extent that real earnings management represents firms’ myopic behavior, innovative firms with a greater need for external capital appear less likely to boost short-term earnings at the expense of long-term values.

Fourth, the better innovation profile of public firms in EFD industries may be a result of patent acquisitions outside firm boundaries. Recent studies provide evidence that public firms have incentives to purchase patents and new technologies through mergers and acquisitions (Bena and Li (2013), Seru (2013)). Sevilir and Tian (2013) show that acquiring innovation can enhance the innovative output of the acquirers. Since the access to stock markets can provide the capital needed for patent purchase, this acquisition-based explanation is actually consistent with the view that public listing provides financing benefits for innovation.

Overall, our results suggest that financing benefits coupled with innovation efficiency and innovative firms’ lower incentives to behave myopically help to explain the difference in the innovation of public and private firms in EFD industries.

The full paper is available for download here.

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