The Financing of Research and Development

Abstract

Evidence on the "funding gap" for R&D is surveyed. The focus is on financial market reasons for underinvestment in R&D that persist even in the absence of externality-induced underinvestment. The conclusions are that 1) small and new innovative firms experience high costs of capital that are only partly mitigated by the presence of venture capital; 2) evidence for high costs of R&D capital for large firms is mixed, although these firms do prefer internal funds for financing these investments; 3) there are limits to venture capital as a solution to the funding gap, especially in countries where public equity markets are not highly developed; and 4) further study of governmental seed capital and subsidy programs using quasi-experimental methods is warranted.

Financial constraints and the failure of innovation projects

“…Financial barriers to innovation projects are closely related to some of their inherent characteristics (Hall, 2002) such as the low return expectation due to an inability to secure profits from an innovation, the higher cost of innovation projects, the high sunk costs, the specific dimension of the physical capital, the presence of externalities and free-riders, among others. All these characteristics reduce the capacity of financial institutions and financial markets to increase sources to firms' innovation projects.…”

“…Furthermore, innovation projects show different characteristics in comparison with other projects. In particular, innovative firms encounter higher external financial difficulties to invest in new R&D projects, because their specific features increase risk and reinforce the informational problems with external investors (Hall, 2002). In fact, innovation is a complex process that frequently fails (Mazzucato, 2013).…”

Finance and R&D Investment: A Panel Study of Italian Manufacturing Firms

“…Data would show a significant, although small, negative correlation between external and internal funding. The two channels of finance, indeed, are not expected to be unrelated, as servicing the debt reduces the cash flow for future investments (Hall, 1990;Hall, 2002;Czarnitzi & Hottenrott, 2011). Note.…”

“…Due to greater asymmetric information problems, SMEs mainly rely on internal finance which, indeed, enters at 1% level of significance. An extensive literature has observed that innovative firms face more severe external financial constraints (Hall & Lerner, 2010;Carpenter & Petersen, 2002b;Hall, 2002;Ughetto, 2008;Hall, 2002;Himmelberg & Petersen, 1994). Whenever possible, that is for sufficient levels of cash-flow, R&D expenditure is covered by internally generated funds, which are not affected by adverse selection problems.…”

“…In other words, given that access to external funding of an innovative firm depends upon a greater presence of asymmetric information problems, it is to be expected that firms, in making their investments, turn first to internal funding and only subsequently to a more expensive external finance (Czarnitzi & Hottenrott, 2011;Ughetto, 2008;Bougheas et al, 2003;Hall, 2002;Hall, 1990). According to Myers (1984) and Myers and Majluf (1984), indeed, there would be a hierarchy in the use of funds, which is based on information asymmetry.…”