ABSTRACT. The empirical evidence suggests that while
small firms in United States, United Kingdom and Canada rely
on internal funds for financing R&D, similar firms in Japan,
Germany and France have access to bank loans. In this paper,
we analyze the financial decisions of small firms willing to
invest in R&D. We find that their high ratio of intangible
assets, along with the high risk nature of their investments,
can explain their inability to raise debt in external capital
markets. We also show that financing R&D with bank loans
might be feasible, especially, if banks are willing to monitor
the investment activities of their clients.
For a long time economists have held the view that
internal finance is the most important method
available to small firms for funding their R&D.
This is apparent in the methodology of early R&D
models that assume that the rate of innovation
depends on the availability of internal finance (e.g.
Kamien and Schwartz (1978) and Spence (1979)).
Developments in the economics of asymmetric
information lent further support to the belief that
liquidity constraints can limit the ability of small
firms to invest in R&D. For example, Arrow
(1962) was first to recognize that moral hazard,
due to risk assessment problems, might prevent
firms from accessing external financial markets
to finance investments in inventive activities.
Furthermore, the works of Leland and Pyle
(1977) and Myers and Majluf (1984) suggest that
high lemons’ premia, because of the inability of
investors to distinguish the quality of R&D
projects, might also hinder the access of firms to
equity markets. Moreover, projects that involve
substantial investment in R&D lack tangible assets
that can be used as collateral which, as demon-
strated by Bester (1985), can mitigate incentive
problems. Finally, another reason for the reliance
of R&D firms on internal finance might be the cost
of revealing the quality of their innovation to the
market (Bhattacharya and Ritter, 1985).
The evidence, especially from small American
manufacturing firms in high-tech industries that
do not have access to the venture capital market,
seems to be in accord with the theory.
example, Hall (1992) finds that R&D intensive
firms do not favor debt as a form of finance,
Hao and Jaffe (1993) suggest that liquidity con-
straints affect R&D spending, Himmelberg and
Petersen (1994) find a large, positive and statisti-
cally significant relationship between internal
finance and R&D spending and Levenson and
Willard (2000) find that liquidity constraints are
tighter for smaller and younger firms. We should
also mention the work of Levin et al. (1987) who
argue that firms regard patents ineffective in pro-
tecting the returns of R&D investments which
supports the Bhattacharya and Ritter (1985)
hypothesis. In contrast, Hoshi et al. (1991) find
that Japanese firms (including firms that belong to
high-growth – high-tech industries) that have close
ties with banks are able to obtain external finance.
The above evidence is consistent with the empir-
ical results in Hall et al. (1998) suggesting that the
stock of liquid assets causes R&D in United States
but not in Japan. Their work also suggests that
firms in United Kingdom and possibly Canada
face the same constraints as those in the United
States while firms in France and Germany operate
in financial environments similar to the one
The above observations raise the
following question: can differences in financial
institutions and corporate governance between
Internal vs External
Financing of R&D
Small Business Economics 22: 11–17, 2004.
2004 Kluwer Academic Publishers. Printed in the Netherlands.
Final version accepted on February 10, 2002
The University of Nottingham
School of Economics
Nottingham, NG7 2RD