Technology and Financial Structure: Are Innovative Firms Different?
GAICIL Insights
A bank cannot repossess an idea.1 That simple fact shapes how the most inventive companies pay for their future. Technology and Financial Structure: Are Innovative Firms Different?, by Philippe Aghion, Stephen Bond, Alexander Klemm and Ioana Marinescu, uses data on publicly traded UK firms to test whether financing choices differ systematically with research and development intensity. The authors examine the debt-to-assets ratio, the probability of issuing new equity, and the shares of bank debt and secured debt in total debt.
Debt follows a curve. Firms reporting positive but low R&D use more debt finance than firms reporting no R&D. Among R&D-performing firms, however, the use of debt falls as R&D intensity rises. Firms with the highest R&D intensities tend to have the lowest gearing. A little innovation borrows; a lot of innovation sells shares.
Equity follows a line. Firms reporting R&D are more likely to raise funds by issuing shares than firms reporting none, and this probability increases with R&D intensity. The most R&D-intensive firms are the most likely to use new equity finance. Meanwhile the shares of bank debt and secured debt in total debt are lower for R&D firms and tend to fall as R&D intensity rises.
The authors read these patterns as largely consistent with the control rights approach. The pecking order among internal finance, debt and outside equity is driven by the interplay among the size of desired investment, the tangibility of assets and the allocation of control rights. Highly innovative firms, with intangible assets and uncertain returns, may find equity more suitable than debt. Who holds the keys matters as much as who holds the cash.
The parallel with today's technology is close. AI firms sit at the far end of this curve. They are typically highly R&D-intensive, with intangible assets such as software, data and human capital. The paper implies they will lean on equity and away from debt, particularly secured debt. Financing the AI economy therefore depends on well-functioning equity markets.
The retreat of bank and secured debt is the sharpest signal. Banks typically lend against tangible collateral, which AI firms may lack. Bank finance may be poorly suited to highly innovative AI firms, leaving venture capital, private equity and public equity markets to carry AI development. A financial system built around collateral will quietly ration the economy's most intangible bets.
The curve's hump also teaches something. Firms with modest R&D borrow more than firms with none, perhaps because they combine some innovation with tangible assets. A manufacturer adopting AI on a moderate scale may keep using debt, while an AI-intensive firm shifts toward equity. Financial systems need to serve both types, and one product will not fit them.
Control rights add depth. Equity investors receive control rights that can help them manage the risks of innovative investment. For AI firms, governance arrangements giving investors appropriate oversight may ease financing, which helps explain the structure of AI financing deals. Board seats and voting terms are part of the price of capital.
Policy follows directly. Supporting venture capital, easing access to public equity markets for innovative firms and avoiding tax biases against equity can strengthen AI financing. Financial regulation that recognizes the distinctive needs of intangible-intensive firms may also help. A tax code that favors debt is, in effect, a tax on intangible innovation.
The empirical design is valuable in its own right. Detailed data on financing choices across firms with different R&D intensities reveal systematic patterns, and similar analyses of AI firms could show how their financing evolves as the technology matures.
Pulled together, innovative firms finance themselves differently. Higher R&D intensity goes with less debt, especially secured and bank debt, and more equity. As AI drives a growing share of investment, the financial system's capacity to provide equity to intangible-intensive firms will be central to sustaining innovation and growth.
Anyone measuring a country's readiness for AI might start here: look past the labs and the chips to the depth of its equity markets. If the money available is mostly secured lending, the most R&D-intensive firms will find the door narrowest exactly where their ambitions are largest.
Introduction
We use data on publicly traded U.K. firms to investigate whether financing choices differ systematically with R&D intensity. As well as looking at a balance sheet measure of the debt/assets ratio, we also consider the probability of raising finance by issuing new equity, and the shares of bank debt and secured debt in total debt. We find a nonlinear relationship with the debt/assets ratio: firms that report positive but low R&D use more debt finance than firms that report no R&D, but the use of debt finance falls with R&D intensity among those firms that report R&D. We find a simpler relationship with the probability of issuing new equity: Firms that report R&D are more likely to raise funds by issuing shares than firms that report no R&D, and this probability increases with R&D intensity. The shares of bank debt and secured debt in total debt are both lower for firms that report R&D compared to those that do not, and tend to fall as R&D intensity rises. We discuss possible explanations for these patterns.
Takeaway
Our results suggest that the financial behavior of more innovative firms, as indicated by the presence and extent of R&D expenditure, differs from the financial behavior of less innovative firms in a number of ways. In Section 2.1 we found an interesting nonlinear relationship with the use of debt financing, as measured by the ratio of total debt to total assets. Firms with positive R&D tend to use more debt than firms with zero R&D, but among the R&D performing sub-sample the use of debt declines with R&D intensity. Those firms with the highest R&D intensities in our sample tend to have the lowest levels of gearing. In Section 2.2 we found a simpler relationship between R&D behaviour and the probability that firms raise finance by issuing new equity. Firms with positive R&D are more likely to issue equity than firms with zero R&D, and the use of new equity increases further with R&D intensity. Those firms with the highest R&D intensities in our sample thus tend to be the most likely to use new equity finance. The overall picture that emerges from these two sets of results appears to be largely consistent with the control rights approach, whereby the pecking order between internal finance, debt and outside equity is driven by the interplay between the size of desired investment, the tangibility of assets, the allocation of control rights, and the investors’ participation constraint.1
More specifically, as we move from less innovative firms to consider firms with increasing R&D intensities: First, more innovative firms may have more attractive investment opportunities and thus become more reliant on external sources of finance, but first prefer for debt as it involves giving up less control rights than new equity; however, more highly innovative firms will have no choice but to issue outside equity in order to meet the investors’ participation constraint. This can potentially explain why the probability of issuing new equity rises monotonically with R&D intensity (as we found in Section 2.2), while the use of debt finance starts to decline eventually as R&D intensity increases (as we found in Section 2.1). Our findings do not fit so well with the dilution costs approach based on informational asymmetries between firms and their outside financiers. On the one hand this approach also predicts that more innovative firms should rely more on external finance (both debt and new equity) than less innovative firms. On the other hand it suggests that the most innovative firms should find new equity finance particularly expensive, which is difficult to reconcile with our finding that among U.K. listed firms, those with the highest R&D intensities are the most likely to issue new equity (Section 2.2). The extent to which bankruptcy costs may help to account for these patterns remains to be explored more carefully.
On the one hand, publicly traded U.K. firms have low bankruptcy rates, so that our sample may not be the best place to look for evidence that bankruptcy costs are a major influence on borrowing behaviour. On the other hand, there is significant variation across listed firms in corporate bond rates, which suggests there may also be significant variation in the perceived risk of bankruptcy. In any case, bankruptcy costs alone cannot explain the finding that, over some range, more innovative firms are more highly leveraged than less innovative firms. In Section 2.3 we analyzed the relationship between R&D intensity and the composition of debt. The shares of bank debt and secured debt in total debt are both lower for firms that report R&D compared to those that do not, and tend to fall as R&D intensity rises. The significance of these patterns is however dominated by cross-sectional differences between firms, and becomes very weak when we control for firm-specific fixed effects and rely on time series variation within the observations on the same firm for identification. There are several extensions to this line of research that we intend to pursue. One important development will be to use other indicators of the extent of firms’ innovative activities than simply their R&D intensity. In this paper, we avoided some of the problems of reliance on R&D intensity by including industry dummies—so that in effect we considered whether the firm’s R&D intensity was high relative to a sectoral norm—and by controlling for firm-specific fixed effects—in which case we further control for the firm’s normal level of R&D activity.
Nevertheless it will be useful to confirm our results using alternative technological indicators.
Notes
- Philippe Aghion et al., Technology and Financial Structure: Are Innovative Firms Different?, 2 J. Eur. Econ. Ass'n 277 (2004), https://doi.org/10.1162/154247604323067989. Takeaway source: 3. Summary and Conclusions, reproduced from a free author or repository copy (working-paper version). ↩
Cite as: Philippe Aghion et al., Technology and Financial Structure: Are Innovative Firms Different?, 2 J. Eur. Econ. Ass'n 277 (2004), https://doi.org/10.1162/154247604323067989
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