How best to finance innovation
Many firms face an innovation problem. They want to innovate their products and invest in research and development (R&D) to boost future growth and gain market share. But especially younger companies are often severely cash constrained. How should these companies finance innovation to maximise their chances of success and the value off their company?
This is the question Denis Schweizer and his colleagues addressed in their work. Looking at publicly listed companies in the US between 1990 and 2015, they differentiated first between companies that issued debt to finance R&D or, alternatively, issued equity. The difference, of course, is that if a company issued equity and the research bears no fruit, third party investors share in the downside. Issuing debt, on the other hand, can leave the company with a lot of extra costs and nothing to show for it.
They found that companies finance initial research and development work predominantly through equity issuance. This could be because of the risk-sharing element of raising equity capital or simply because young and small companies may not have access to debt-financed growth. Or the cost of such debt would be prohibitively high. Whatever the reason, companies that do raise equity are significantly more prolific on the R&D front in the years after the equity raise than companies that raise debt capital or no capital at all. This can for example be shown by looking at the number of patents granted.
Number of patents after a secondary equity offering (SEO)
Source: Schweizer et al. (2022)
However, once the initial research has been done and a product has been developed to a stage where it can be called “market ready”, the companies that are most successful then typically issue debt to finance the investment needed to bring a product to market. In other words, once it is sufficiently likely that a new product will be successful, there is no point in raising additional equity and dilute the potential profits from launching the product. Instead, the upside should be shared among existing shareholders.
Debt financing for innovation after SEO
Source: Schweizer et al. (2022)
And the market rewards this kind of financing strategy (first equity to finance basic R&D, then debt to finance going to market). Tobin’s Q, the ratio of the market value of a company divided by the replacement cost of its assets, is about 30% higher for companies that follow this financing strategy compared to other companies that follow different strategies.