Using bank loans to finance innovation

There is a new paper on the role of bank loans in innovation — Beg, Borrow, and Deal? Entrepreneurship and Financing in New Firm Innovation by Sheryl Smith of Temple University. Using data from Kauffman Firm Survey (KFS), she looks at the financing of start-up. She also reviews the theoretical literature of why entrepreneurs would choose equity or debt financing and the relationship of that decision to innovation and risk. The findings point to why fostering the opportunity for debt financing may benefit innovation:

With regard to debt financing, the evidence in this paper suggests that information asymmetry combined with technical risk influences the ability to secure bank financing. Banks, unlike providers of equity finance, do not share in a potential upside of a high growth firm. However, there is evidence that as information asymmetry is lessened over subsequent periods, banks are more likely to lend to high tech firms. As the riskiness of a high-tech firms decreases, they are increasingly likely to receive business bank loans over time, suggesting the likelihood of business bank loans targeting the firms, over time, with higher growth potential. This is consistent with the literature on bank lending to new ventures, and in particular the role of monitoring and risk reduction in bank lending to entrepreneurs.

The results of the probit [a statistical technique] estimations in this paper suggest that increasing leverage over time might provide nascent technology entrepreneurs with financial slack that may enable with innovation. This implication bears closer attention in further work. The entrepreneur launching a new technology venture faces significant resource constraints, and the attendant need to secure financing. For firms with adequate financial resources, lower leverage, i.e. debt relative to total debt plus equity, is associated with greater financial slack and enhanced innovation. In this case, lower leverage would be necessary for firms competing significantly on the basis of innovation (O’Brien, 2003). However, when financial resources are highly constrained, as in a new entrepreneurial venture, the relationship between slack and performance is nuanced (George, 2005). While traditionally the finance literature associates increasing leverage with lower innovation, it seems highly plausible that in truly nascent technology firms additional debt relaxes the major capital constraints faced by the entrepreneur.

From a public policy point of view, that conclusion begs the next question: how can we help those nascent technology firms access that debt as appropriate? We have long advocated the use of IP and other intangibles assets as collateral on loans. As noted in an earlier posting, the KFS will be asking more in-depth questions on company borrowing, including whether they are putting up their IP as collateral. That will give us some idea to the extent of the practice. More survey’s would also be useful — specifically of banks and other lenders. And we need to move forward on creating underwriting standards for intangible-backed loans. Smith’s research point the way toward understanding the positive role debt financing plays in innovation. We should build upon and expand that work.

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