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Financing Innovative Small and Medium-Sized Enterprises in Canada

II. Literature Review

Many studies have investigated the capital structure of firms. Ben-Ari (2007) finds that knowledge-intensive firms tend to rely largely on equity financing. Baldwin and Johnson (1995) find that innovative firms rely more heavily on outside sources, such as venture capital, public equity, and parent companies and affiliates for sources of financing and rely less heavily on suppliers and financial institutions. Using data on publicly traded United Kingdom (U.K.) firms, Aghion et al. (2004) investigate whether financing choices differ systematically with research and development (R&D) intensity. The authors find a nonlinear relationship with the debt/asset ratio: firms that report positive but low R&D use more debt finance than firms that report no R&D. The use of debt finance falls with R&D intensity among those firms that report R&D. The authors 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. Baldwin, Gellatly and Gaudreault (2002) suggest that the relationship between knowledge-intensity and capital structure is bi-directional. The authors find that, after controlling for a range of industry- and firm-level covariates, firms that devote a higher percentage of their investment expenditure to R&D also exhibit less debt-intensive structures. Conversely, debt-intensive structures also act to constrain investments in R&D.

The question of whether the financing experiences of innovative firms differ from those of other firms is investigated in several studies. Westhead and Storey (1997) develop a variety of regression equations using information from a survey of 171 SMEs located on and off science parks in the U.K. The equations regress the degree of difficulty in obtaining finance on a wide range of firm characteristics, including: the extent to which the firm is high-tech (R&D expenditure in relation to turnover, the number of qualified scientists engaged in R&D in relation to total employees, and the number of patents taken out in the last year); the age of the firm; legal status; industrial sector; growth rate; profitability; and location. The authors conclude that firms with relatively high R&D expenditures are more likely to report continuing financing constraints. Based on data from a sample of small firms in Northern Britain that applied for a bank loan over the period 1998–2001, Freel (2007) records that the proportion of loan successfully applied for and estimates a series of tobit models using a number of proxy measures for innovation (in terms of inputs, outputs, and commercial significance to the firm). Results show that the most innovative firms are less successful in obtaining loans than their less innovative peers.

The literature has shown that capital structure and financing experiences of more innovative firms are different from those of less innovative firms. However, to our knowledge, no study in the economic literature has used R&D expenditure in relation to total investment expenditure to define innovative firms. Therefore, in this paper, 20 percent of total investment expenditures spent on R&D is used as a cut-off to define innovative and non-innovative firms. We will see if the results are similar to those presented in the literature using other proxy measures for innovation.

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