LESSON 10: FINANCING INNOVATION

Why is finance important for innovation?

Finance plays a critical role in innovation as it allows organizations to conduct research, adopt
technologies necessary for inventions as well as develop and commercialize innovations.
Accessing external finance for innovation is an important challenge for firms . Firms can fund
innovation activities using a variety of funding instruments provided by different types of
financial intermediaries and investors. Access to external sources of finance is often particularly
challenging at the seed and early stages of business development as at this stage companies face
high barriers for accessing finance notably as they lack a track record.

What is the role of finance for innovation?

Both funding needs and funding availability are closely related to the stage of development of
the firm and its innovation projects.

MGT 314-Innovations Management Notes

• In the initial phase when inventions are developed and research conducted, there is still
much uncertainty about what innovations will emerge, if any. This makes it very difficult
to obtain funding. These financial constraints are one of the reasons why policy typically
plays an important role at funding the early stages of technological development.

• At more advanced stages, with the development of prototypes and the commercialisation
of inventions, specialized investors who are skilled in assessing new technologies and can
handle risk, such as venture capitalists and business angels, become more willing to
provide funding.

• In the final stages, at the level of technology diffusion and adoption, once both
technological and market uncertainty have all but disappeared, more traditional suppliers
can provide the required funding to scale up operations as well as to finance purchasers
interested in adopting new innovations.

It is worth noting that even if the innovation process may involve the same stages in small
start-up and a large multinational, the sources of finance that they have available vary
significantly. Large firms can more easily finance their R&D activities, whether using internal
resources, getting a loan from a bank (using their tangible assets as collateral if required),
issuing bonds, or raising equity finance in the stock markets. Start-ups do not have as many
assets to use as collateral and their innovation investment is less diversified, and may also
represent a much larger share of their activities for really innovative firms. As a result, their
funding options are much more limited, and often need to rely on friends and family before
being able to access other sources of capital.
What are the sources of finance for innovation?

Firms can use either internal or external sources of finance to fund their innovation activities.

• The main internal source of finance is retained earnings, the profits accumulated over time
which have not been returned to shareholders. Firms typically prefer to use internal
financing rather than external financing as the latter can be very costly. As a result, there
are projects that firms would choose to undertake if they had sufficient internal resources

MGT 314-Innovations Management Notes

 available, but which will not be taken forward if firms need to access external finance to
develop them. In many cases firms do not have the option to access external financing.

• In contrast, external sources of financing includes debt and equity (as well as some hybrid
forms), which can be provided by individual investors (such as business angels), venture
capital funds, banks and capital markets (among others). Conditional on having to resort
to external funds, debt is generally preferred to equity, since if available debt is typically a
cheaper source of finance (even if still more expensive than internal funds).

What is the framework for financing innovation?

Markets require a set of well-functioning institutions in order to work, so institutional failures

can severely damage access to finance for innovators. This includes the following conditions:

Intellectual property rights can facilitate access to finance for innovative firms, since they
turn knowledge into a commodity that, among others, can be used as collateral to obtain
funding, and also as an asset that can be salvaged by equity investors if the firm fails (see
Intellectual Property Rights - FI).

The design of the bankruptcy code has an important influence on financiers‘ decisions
to provide the funds to make it happen (see Bankruptcy regulation).

Developed financial institutions (see Financial market development) are crucial for firms
that need external funding to invest in innovation. Financial market regulation (see
Financial market regulation) can shape how financial intermediaries evolve, and the
resulting structure of financial institutions in a country, which in turn may impact on the
types and sources of innovation activity.

External sources for financing innovation

External sources of finance are critical for firms‘ innovation as firms typically lack internal
sources (e.g. retained earnings and profits) for financing their innovation projects. They
critically depend on how financial markets operate and on the rewards they provide to
innovators (see Markets and rewards for innovation).

MGT 314-Innovations Management Notes

 External sources for financing innovation include:

Debt financing, which refers to opportunities for firms to secure public and private credit
to start and develop their businesses (i.e. loans from banks and public institutions), is used
as one of the most common tools for access to finance.

Stock market financing, which refers to raising capital by issuing shares or common stock
in stock markets can also be used to obtain financing. Yet, it may be of limited relevance
for financing innovation whose outcome is uncertain and for innovative new venture,
which often have, at least initially, negative cash flows, untried business models and
uncertain prospects of success.

Business angels: wealthy individual investors, typically with business experience, who act
as a source of equity and provide start-up capital (as well as expertise and access to
networks) to smaller firms in exchange for either convertible debt or equity. In recent
times, business angels are establishing networks in order to better link firms with
investors. Business angels attempt to identify firms which seem promising but lack the
necessary funds to implement innovative strategies. As a result, angel investors play a key
role in providing finance to younger firms.

Venture capital: venture capital funds can be defined as pool of capital which is managed
professionally and is invested in private ventures using preferred stock or similar instruments.
Venture capital funds have developed significant expertise on how to undertake due diligence
for high-risk innovative firms as well as how to structure the contracts and stage the funding
provided in order to reduce the impact of informational asymmetries.

Other types of finance, such as subsidies and grants from governments and international
organizations can also be critical given innovative businesses‘ limited access to financial
markets.

Internal sources for financing innovation

Internal sources of finance are critical for firms‘ innovation activities. This includes notably
retained earnings, the profits accumulated over time which have not been returned to
shareholders. Firms often use internal financing rather than external financing.

MGT 314-Innovations Management Notes

 Several factors shape firms‘ decisions to allocate their own resources to financing innovation:

Sources as diverse as money and capital provided by family and friends to start a business
as well as entrepreneurs‘ personal financial resources can be important resources for
innovative entrepreneurs (see Private sources of funding). Private sources of funding are
often essential for start-ups since information asymmetries often render access to finance
on markets difficult. They can help entrepreneurs obtain debt financing, along with
funding from venture capital and business angels. Public policy can play a role by
establishing bankruptcy regulations so that innovative entrepreneurs will be more willing
to invest in innovative businesses.

Large firms with multiple divisions can fund their innovation investments in one division,
even if a new one, with retained earnings from other divisions. In this case, corporate
headquarters allocate scarce funding across different divisions in an internal capital
market, using a variety of mechanisms to select what competing projects to fund. The
importance given to innovation activities will be particularly critical in this context (see
Resource allocation mechanisms within firms).

The separation of ownership and control can also lead firms to display short-terminist
behaviour. This is a concern in particular for companies that are listed in the stock market
and have a diversified shareholder base. For a variety of reasons stock market prices may
fail to accurately reflect firms‘ investments in innovation (among others) and the returns
that they are expected to generate in the long term. As a result, myopic behaviour by
financial intermediaries can sometimes punish management teams that heavily invest in
innovation activities, since investors observe lower profits today but fail to appreciate the
higher long-term profitability that is expected. There is an on-going debate on whether
private equity is a good alternative to focus managers‘ attention on long-term profitability.
While it might insulate managers from having to satisfy market expectations, it might lead
to prioritize medium-term profitability (see Long-term and short-term profit objectives).

• Moreover, the competitive environment can impact how many internal resources are
available for innovation. Firms can recoup the fixed cost of investing in innovation by

selling the resulting product at a price that is higher than the marginal cost of
producing it. Firms use a variety of strategies to sustain this mark-up, such as
MGT 314-Innovations Management Notes
 using intellectual property (e.g., patent the invention), first-mover advantage
(e.g., build a large consumer base) or secrecy. However, these strategies are not
always successful in practice, so if markets are very competitive it can be
difficult to sustain a mark-up to cover the costs of the innovation process. This
is why there is some research suggesting that there is an inverse-U-shaped
relationship between competition and innovation. Without competition there is
very little pressure to innovate, but with too much competition investors may be
reluctant to fund innovative activity if they fear that even if successful it will be
difficult to capture the benefits of this success (see Competitive environment
and resources for innovation).

Finally, while having access to internal resources facilitates investment in

innovation by avoiding many of the challenges that arise for firms as they seek
external sources of finance, it also makes it easier to undertake potentially
unproductive investments. Not being required to convince external providers of
finance gives managers the freedom to use their firms‘ retained earning with high
discretionality. This can be good if it leads to profitable investment that would not
happen otherwise, but bad if CEOs spend these funds on activities that are
beneficial to them rather than to maximize long-term shareholder value.

MGT 314-Innovations Management Notes