Financing Innovation

by William R. Kerr & Ramana Nanda

Overview — There is growing consensus that well-functioning financial markets play a central role in driving economic growth through their ability to spur technological innovation. In this paper for the Annual Review of Financial Economics, the authors ask how financial markets might actively shape the nature of R&D that is undertaken. They also examine how this may impact technological innovation and growth through the shaping of the ideas that are developed across firms. Drawing on a new but growing literature on the role that capital markets and financial intermediaries play in impacting firm-level innovation, the authors first elaborate on theoretical contributions regarding why financing R&D projects might be distinct from financing other types of projects and the channels through which financial intermediaries and capital markets can impact innovation. They then discuss empirical studies on financing innovation in mature firms, in particular the literature on how ownership and capital structure impact the amount and nature of innovation undertaken by firms. The paper also looks at innovation in startups and the growing literature on the effect that multi-stage financing has on innovation in young firms. Three main themes emerge: 1) A growing body of work documents a role for debt financing related to innovation. 2) A very active area of research has looked at "learning" across multi-stage financing. 3) There is strong interaction between financing choices for innovation and changing external conditions. Key concepts include:

Financing constraints can be extensive in the context of firms engaged in R&D and innovation-with the ability to shape both the rate and the trajectory of innovation.
Capital structure plays a central role in the outcome of innovations.
Bank finance is an important source of finance, particularly for larger firms with tangible and intangible assets to pledge as collateral.
Public markets may provide deep pockets but pose a set of agency costs that might be particularly harmful for firms engaged in exploration and novel innovations.
There is a growing interest among academics and practitioners in the multi-stage financing of innovation, both in established firms and startups, and understanding the optimal contracts and policies that might stimulate innovation.

Author Abstract

We review the recent literature on the financing of innovation, inclusive of large companies and new startups. This research strand has been very active over the past five years, generating important new findings, questioning some long-held beliefs, and creating its own puzzles. Our review outlines the growing body of work that documents a role for debt financing related to innovation. We highlight the new literature on learning and experimentation across multi-stage innovation projects and how this impacts optimal financing design. We further highlight the strong interaction between financing choices for innovation and changing external conditions, especially reduced experimentation costs.