Finance and Corporate Innovation: A Survey

Jie (Jack) He is Associate Professor of Finance and BB&T Scholar at University of Georgia Terry College of Business, and Xuan Tian is JD Capital Chair Professor of Finance at Tsinghua University PBC School of Finance. This post is based on their recent paper.

Corporate innovation has become an increasingly important topic that attracts a great deal of attention from academic researchers in financial economics in recent years. How to motivate and finance corporate innovation? To what extent do financial markets and systems shape the initiation, process, features, and outcomes of technological innovation by corporations? These questions are particularly important to investors, business practitioners, social scientists, as well as policy makers due to the fact that technological innovation is vital for a country’s economic growth and a firm’s long-term competitive advantage. Given the important roles played by technological innovation, more and more financial economists have started exploring a wide spectrum of firm-, market-, as well as country-level determinants of corporate innovation over the past few decades. Although the top three finance journals (i.e., the Journal of Finance, the Journal of Financial Economics, and the Review of Financial Studies) together published a total of only 5 papers on the topic of corporate innovation between 2000 and 2008, the number of such papers published by these three journals has skyrocketed to 56 ever since 2009 (until 2017Q3). This newly emerged strand of research generally has two central themes: (1) how to best motivate corporate managers to invest in innovation; and (2) how to finance innovation efficiently.

This paper aims to review the recently fast-growing literature on finance and corporate innovation. Our main purpose is to provide a synthetic and evaluative monograph of academic papers that examine the drivers and financing sources of corporate innovation. By doing so, we hope the readers can obtain a comprehensive perspective on the recent development of this line of research, understand the differences and interconnectedness among various topics, and have a better clue on where the direction of future research lies.

We survey both published papers in top journals and unpublished working papers that have been presented in high-quality academic conferences in this area over the past decade. A central question explored over the past decade is how to effectively motivate corporate innovation, which is very different from motivating routine tasks. Unlike routine tasks that follow conventional technology and generate quick returns, innovation is a long-term, risky, and idiosyncratic process that entails great patience, adventurous spirit, and a willingness to experiment with new, unexplored methods. At the same time, firms engaging in innovation activities tend to make partial disclosure due to both strategic reasons and the nature of the innovation process, and thus are likely to be opaque and suffer from undervaluation. Hence, the investment of innovative projects is prone to various kinds of market frictions, such as moral hazard, managerial myopia, and information asymmetry, all of which prevent innovative firms from obtaining an efficient access to the capital market and from making optimal innovation decisions. In our survey, we review academic studies that examine how innovative firms are affected by various market frictions and how they might be able to overcome these difficulties.

The survey consists of four sections. The first section reviews the literature that links micro-level firm characteristics and innovation activities. We discuss papers that explore how venture capital and entrepreneurship, as well as firms’ internal and external characteristics influence the process, features, and outcomes of innovation. The second section covers studies examining the relation between market-wide economic forces (such as product market competition, import penetration, banking deregulations, market conditions, etc.) and firms’ incentives to engage in innovative investments. The third section analyzes the literature on how macro-level social or country characteristics (such as a nation’s institutional features, laws and policies, financial market development, etc.) affect corporate innovation.

In the final section of our survey, we discuss a few of our observations and own views on the future direction for research that explores the relation between finance and corporate innovation. First, we think that it is important to develop new empirical proxies that better capture the extent of corporate innovation activities than self-reported R&D expenditures and patenting-based measures. Self-reported R&D expenditures (especially those reported in a public firm’s financial statements) used to be the primary proxy for a firm’s innovation activities in the economics and finance literature due to data availability. This proxy, however, has several critical limitations, which motivate researchers to explore viable alternative measures for innovation. In the past decade, patenting has been frequently used as an alternative proxy to capture corporate innovation. In fact, the vast majority of the studies reviewed in this survey use patent-based measures to gauge the extent of corporate innovation activities. Superior to R&D expenditures that only capture one particular observable input of innovation, patenting is an innovation output variable, which encompasses the successful usage of all (both observable and unobservable) innovation inputs. Due to the richness of the patenting data, researchers could analyze not only the quantity of innovation outputs but also the quality and fundamental attributes of them, such as their impact (citations), generality, originality, and their relevance for a firm’s core businesses. In addition, patent data are available not only for publicly traded firms, but also for privately held firms, organizations, and even individuals. Patenting, however, is not a perfect proxy for innovation either, and subject to various limitations as well. Hence, a few attempts to develop new innovation measures have been made in recent years, such as the market-perceived value of patents at the time of granting, the firm-specific output elasticity of R&D expenditures, as well as text-based innovation measures using financial analysts’ reports or press releases.

Another fruitful direction for future research is to examine the real and stock market consequences of corporate technological innovation. The vast majority of the literature reviewed in this survey studies how a variety of firm-, market-, country-level characteristics affect corporate innovation. A natural question is whether and how corporate innovation affects a firm’s real and financial performance, as well as its ownership structures and key firm characteristics. For example, do innovative firms grab more market share from its major product market rivals, are more likely to enter a new market, and enjoy higher operating performance? Do they hire more productive workers and managers with better skills? In turn, do innovative firms exhibit long-term growth, better stock returns, and higher market valuation? Also, are innovative firms suitable for certain ownership/governance structures and financial policies, and do they want more or less publicity? In terms of labor market consequences, do innovative firms spawn entrepreneurs and especially spur local entrepreneurship? Finally, how does corporate innovation at the aggregate level affect a region’s or nation’s entrepreneurship, employment, financial development, and economic growth? While some of the existing papers address a few of the above issues to certain extent, more research along this line is needed and fruitful. In particular, future studies should look for clean empirical settings and develop clever identification strategies to identity the causal effect of corporate innovation on the real economy and financial markets.

The complete paper is available for download here.

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