INTERNATIONAL CONFERENCE

FINANCIAL SYSTEMS, CORPORATE INVESTMENT IN INNOVATION AND

VENTURE CAPITAL

CEPS, 1 Place

INNOVATION AND NEW TECHNOLOGIES: CORPORATE FINANCE

AND FINANCIAL CONSTRAINTS

Dorothée Rivaud-Danset

E-mail: dorotheerivaud@noos.fr
Professor, University of Reims and CEPN-CNRS (Paris 13)

Jointly Organized by the European Commission-DG Research and the Institute for New
Technologies of the United Nations University, 7 and 8 November 2002. Conference venue:
CEPS, 1 Place du Congrès, 1000 Brussels.

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During the last decade developments in the new technologies have generated growing interest
in the question of financing innovation. According to economic theories, demand of financial
flows for innovative projects will be rationed by capital suppliers, even if the project is
promising. Asymmetry of information between those who manage an innovative project, on
the one hand, and suppliers of capital, on the other, is believed to be intense. Asset patterns
are atypical, with a high rate of intangible assets which mirrors the weight of R&D expenses;
for lenders, such assets give little guarantee per se, because in the event of bankruptcy their
value decreases sharply, as they are specific to the firm. The contractual nature of the debt
contract as opposed to the shareholder’s residual rights on earning is another factor
contributing to lender reluctance. According to the economic literature, bank loans are likely
to remain a limited source for financing innovative projects and firms, whereas the role of
market financing is more controversial. Testing the predictive capacity of the above-
mentioned theories is not easy. The most familiar financing pattern for innovative projects in
the European Union is not well established, as there is no specific survey on this topic. As
regards the financing of New Economy firms, the lack of evidence is even greater.

For the ‘New Economy firms’ - i.e. for the set of firms offering goods and services which are
classified in the New Economy sectors -, the main features of the financing of innovation are
amplified: asymmetry of information is higher and the return-risk of a project or firm is
difficult to assess, given the numerous sources of uncertainty surrounding the success of a
project. Investment decisions are based on expectations that are highly sensitive to ‘market
mood’ and, as a consequence, the New Economy financing issue is not only associated with
constraints at a firm level but also with instability at a macro-level.

The scope of this paper is limited to a microeconomic approach. With the help of empirical
data collected through official surveys, this paper aims to provide evidence and arguments
which may help in answering the following questions: To what extent are innovative projects
constrained by financial obstacles (part I)? What is the ‘pecking order’ or, in other words, the
mode of funding innovative projects (part II)? Do new technology based firms face capital
scarcity (part III)?

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Part I. To what extent are innovative projects constrained by financial
obstacles?

Not only are surveys about the financing innovation issue infrequent, but when such surveys
are carried out the relevant data often remain quasi-confidential. This is true of the
Community Innovation Survey (CIS) organised in Europe by Eurostat and national agencies.
The second CIS, carried out in 1997-1998, collected information about corporate innovative
behaviour during the period 1994-1996 and provides the core empirical material of this
section. Surveys on French innovative firms, which also use the CIS2 framework, help to go
further in this inquiry, as they give more detailed data.

Although the Community Innovation Survey does not deal with the structure of innovative
financial resources, it includes one question which is quite relevant for my topic. Indeed, part
of the survey deals with factors experienced by enterprises during the period under review
which hampered innovation activity. ‘Lack of appropriate source of finance’ is mentioned as
one of the nine hampering factors listed in the survey. The importance of each hampering
factor is categorised according to the state of the innovative project: seriously delayed,
abandoned or not yet started (see box 1).

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 Box 1
The CIS2 is based on Oslo definitions. It includes questions about the obstacles met by firms, either innovative
or not, which seek to introduce an innovation leading to a new or an improved product, and/or to an innovation
process. This survey was conducted in 1997-1998, in the fifteen European Community countries, using 1996 as
the year of reference. The nine obstacles which have been listed can be grouped in a different way to that used
for the CIS2 grouping, as follows:
. Economic obstacles are represented by the questions worded: ‘excessive economic risk’, ‘too high innovation
cost’, and ‘lack of appropriate source of finance’. This last question, in this paper, is called the financial obstacle
or the financial factor.
. Market risk is represented by the questions ‘lack of consumer responsiveness to new product’ and ‘lack of
information on markets’.
. Other obstacles groups together:
. the obstacle caused by lack of human resources represented by ‘lack of qualified personnel’
. the organisational obstacle represented by ‘organisational rigidity’
. the regulatory obstacle represented by ‘problems of regulation fulfilling’
. the technological obstacle represented by ‘lack of information on technology’.
Data for European countries is available on an aggregate level, by sector and by size, and not on an individual
level. The capacity for data processing is therefore limited. Although the sample of innovative firms is always
large, even when the country is small (the number of firms ranges from 81,750 in Germany to 1,864 in Finland),
sector analysis encounters difficulties due to the limited number of firms, as, for example, in the case of
telecommunication sector, and due to the chosen classification which only allows a few sectors to be identified.
Italy is a special case as the survey only covers manufacturing firms and the quality of answers to the list of
obstacles is subject to reservation. Countries have been selected so that the sub-sample includes the larger
European countries (Spain is not in the database), and two small countries orientated towards innovation, with
distinct financial institutions.
Supplementary information is displayed in Appendix 1.
This report also refers to a study which uses individual data collected for the CIS2 by SESSI, the statistical
department of the French Minister of Industry, but these two studies only cover manufacturing industries. The
French database is more detailed than the publicly available European database. For instance, the French
database takes into account a sub-sample of non-innovative firms, whereas the study at the European level does
not. Firms qualified as non-innovative had undertaken innovative projects but none of them had been completed
during the period 1994-1996.

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This section, firstly, presents evidence1 using the CIS2 database which covers the
manufacturing and service industries of six European countries, namely Finland, France,
Germany, Italy, the Netherlands, and the U. K. It focuses on the relative importance of the
financial factor among all the hampering factors listed. Secondly, more detailed evidence is
given, drawn from French studies carried out by SESSI and the Banque de France, both using
the CIS2 database.

I. 1. Evidence from the Community Innovation Survey

Firms which aim to innovate meet obstacles, the consequences of which are classified into
three groups: the innovation project (1) faces serious delays; (2) has been abandoned; (3) has
not even started. The percentage of innovative firms which accumulate delays, abandon
innovative projects or cannot start an innovation project, varies from one country to another,
but is always significant, ranking from:
. 27.4 % in the U. K. to 54.8 % in France, for innovation projects facing serious delays,
. 12.1 % in the U. K. to 22.0 % in the Netherlands, for innovation projects that have been
abandoned,
. 20.3 % in the Netherlands to 50.3 % in Finland, for innovation projects that have not even
started.
Table A.1 in the appendix provides more detailed data.

Not surprisingly, CIS2 demonstrates that small firms are more financially constrained than
their larger counterparts. In the six selected European countries, the financial obstacle is more
important for small firms (< 50 employees) than for larger ones (> 250 employees), whatever
the state of the innovative project. This regularity is observed for manufacturing firms and for
services, with only two contrary cases over 30 (cases are aggregate observations, see table A.2
in the appendix for abandoned projects). In most countries, if an innovative project is
seriously delayed, the financial factor, relatively to the other hampering factors, is more
frequently quoted by small firms than by large ones (Table 1.1). The gap between the
percentage of firms having quoted the financial factor as an obstacle and the first listed
obstacle is wider in the case of large companies, which also indicates that large firms are less
financially constrained than small ones.

1
Data has been processed with the assistance of V. Revest.

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Table I. 1. The weight of the financial factor among the hampering factors for
innovating firms in the service sector with seriously delayed projects, by size

Small firms (10-49 U. K. France Germany Netherlands Finland

employees)
. weight of the 1 5 3 8 6
financial obstacle
. gap between the first 0 17.7 26.9 34.4 20.9
obstacle and the
financial obstacle
. average number of 1.8 2.4 2.0 2.2 2.6
obstacles

Large firms (> 250) U. K. France Germany Netherlands Finland

. weight of the 3 9 8* 6 9
financial obstacle
. gap between the first 33.4 18.3 60.5 53.0 60.0
obstacle and the
financial obstacle
. average number of 1.7 1.7 2.0 2.1 2.6
obstacles

Sources: Own calculations, CSI 2

The rank of the financial factor depends on the frequency of firms which quoted this obstacle. The number of
obstacles quoted by one firm is not limited.

In all the European countries under review financial constraint is important, but except for the
U.K. is it not ranked number one, as the lack of appropriate sources of finance is not the most
frequently quoted obstacle, whatever the state of difficulty of the innovative project. The main
obstacles vary according to the state of failure of the innovative projects.

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Table I.2. The financial obstacle among factors hampering innovative projects

U. K. France Germany Netherlands Finland Italy

Projects not even started
. total manufacturing 1 3 3 5 3 3
. total services 1 3 1* 3 3 NA
. Total 1 3 2 5 3

Seriously delayed projects

. total manufacturing 1 9 7 9 7 2
. total services 7 5 3* 8 6 NA
. total 1 7 3 8 7

Abandoned projects
. total manufacturing 2 4 6 7 NA 3
. total services 3 3 1* 9 NA
. total 2 3 4 7

Sources: Own calculations, CIS2.

* indicates that for 1 or 2 factors there is no answer. NA indicates that the number of factors without answer is
superior to 2, so that the rank of the financial obstacle cannot be accurately determined, as rank is estimated by
the frequency of answers.

. If a project has not even started, the obstacles are above all economic. ‘Excessive economic
risk’ and ‘too high innovation costs’ are the most often-quoted hampering factors in four of
the six countries selected (table 1.2 and table A.3 in appendix); for these four countries,
financial constraint comes in third position as it is mentioned by a lower percentage of firms.
In Germany, it comes in second position and in the U. K. in first place. Generally speaking,
the financial factor is important, although less prominent than risk and cost, the two other
economic hampering factors. As a risky and costly project is more likely not to be funded than
a low-risk, low-cost project, it is tempting to assume a correlation between these obstacles,
although it is not possible to test this with aggregate data.

. if the innovative project comes up against obstacles which entail serious delays, new
obstacles, due to human resources and organisation, come to the forefront. In Finland, France

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and the Netherlands, the lack of qualified personnel becomes the most frequent hampering
factor and, as a consequence, the lack of financial resources becomes of minor importance,
being ranked in seventh position. In the U. K., financial constraint is always of major
importance.

. two kinds of risks lead to project abandonment: economic risk, which had been undervalued
at the beginning, and market risk, because of the ‘lack of consumer responsiveness to new
product’. The financial constraint rank varies from one country to another, from second
position in the U. K. to seventh in the Netherlands. In some particular sectors of activity, such
as shipbuilding, some business services, or for small firms, the market risk is amplified by the
small number of customers. The link between market risk and lack of funds is obvious, when
the withdrawal of a big customer entails immediate financial difficulties and both obstacles
may lead to the abandonment of the project.

With the exception of the U. K., financial constraint is better analysed as a hampering factor
whose impact should correlate with the other problematic characteristics of innovative
projects: cost, economic risk and market risk. In the continental European countries under
review it appears that perceived difficulties come mostly from the innovative process itself, as
economic risk and innovation costs predominate in explanations of why a project has not even
started, and are often quoted to explain project abandonment. Another motive – the lack of
consumer responsiveness - is also linked to the innovative project itself and not to the
availability of factors of production. CIS2 data suggests that in these countries the lack of
financial resources is not perceived as an exogenous constraint, even if it is quoted by many
firms as one of the main factors in explaining innovation difficulties.

The U. K. represents a special case. The lack of financial resources seems to be perceived as
an obstacle per se, as it is the handicap quoted by the highest number of firms, whatever the
state of project. According to CIS2, difficulties encountered in the U.K. in undertaking
innovative projects are mainly due to a lack of means, namely the lack of appropriate
financial and human resources. This latter obstacle also appears in the other countries. Indeed,
in the continental European countries in the survey the lack of human resources is the most
important explanation for the delay of an innovative project, whilst it is seen as a minor
handicap in the two other categories. This data supports the idea that the British economy
suffers from specific problems of coordination between financial investors and entrepreneurs.

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To sum up, the lack of financial resources is an important obstacle to innovative activity
among continental European firms, but it is not the most important. According to the
asymmetry of information effect, financial actors, either bankers or market investors, are often
analysed as if they were ‘myopic gatekeepers’ who tend to ration capital because they
undervalue good projects, as they cannot discriminate between promising and risky ones
(Myers, 1984). Answers given by managers of innovative firms to CIS2 do not invalidate the
idea of a certain short-term approach which may characterize capital suppliers, inclined to
ration funds needed by innovative firms, even if these latter bear promising projects.
However, there is room for another interpretation where the financial constraints directly
correlate with the economic risk of the project. As stated previously, the company may come
up against financial difficulties as a consequence of the uncertainty surrounding the
profitability of a new product or process (this uncertainty - called ‘economic risk’ - is usually
estimated by the standard deviation of anticipated return). If the economic risk of an
innovative project is deemed to be too high, a perfectly well-informed financial Director may
ration funds for such project. Where the market risk is perceived as higher than expected at
the beginning, managers and investors reappraise their expectations about profitability, and
the lack of financial resources becomes a kind of ultimate obstacle.

I. 2. Supplementary evidence from French databases

Two French empirical studies connected with CIS2 help to go further in this investigation,
with the result that the asymmetry of information thesis becomes more subtle than in the
standard view.

The database provided by SESSI - the statistical department of the French minister of Industry
- as a contribution to the second community survey on innovation helps us to understand how
the financial factor can be a hampering factor for innovative activity. This database allows us
to distinguish between innovative and non-innovative firms (box 1) as in table 1.3.

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Table 1.3 Average number of obstacles, by state of project, met by:

. total innovative firms, with innovative project

suffering serious delay abandoned not even started
2.5 1.9 2.3

. the sub-sample of innovative firms, with innovative project hampered by a lack of

financial resources,
suffering serious delay abandoned not even started
3.9 3.1 4.2

. total non-innovative firms, with innovative project

suffering serious delay abandoned not even started
2.7 2.9 4.8

. the sub-sample of non-innovative firms, with innovative project hampered by a lack of

financial resources
suffering serious delay abandoned not even started
4.9 5.0 8.2

Sources: SESSI 1997-CIS2; manufacturing firms with 20 employees and more

When an innovative project encounters financial constraints the average number of obstacles
nearly doubles, whatever the state of difficulties of the innovative project. For instance, for
the total set of innovative firms with a not-even-started project (2,689 individual
observations), 2.3 is the average number of listed obstacles, and for the sub-set of firms with
financially constrained projects (704 observations), 4.2 is the average number of listed
obstacles. Evidence is more impressive for the sub-set of non-innovative firms: when the
project has not even started, and is financially constrained (1,375 observations), the average
number of obstacles reaches 8.2 out of a total of ten obstacles (the SESSI-CIS2 database
includes a tenth motive called ‘cooperation failure’ which does not figure in the CIS2
database). Clearly, in this latter case, it is better to analyse the financial obstacle as the

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ultimate obstacle that puts an end to bad innovative projects rather than as the leading obstacle
that impedes good projects. Whatever the state of difficulties of the innovative project, when
it is financially constrained, economic risk and high cost are the more frequently quoted
obstacles, especially for non-innovative firms. Evidence from the French database supports
the previously-mentioned view that financial constraint is not perceived as an autonomous
factor in the European continental countries. The lack of skills is an obstacle per se, the lack
of financial resources correlates with risk and cost. When the innovative project is perceived
as too costly and too risky and/or the number of other obstacles is high, managers can hardly
convince financial investors to allocate resources, even if they are members of the same
corporate group sharing the same information.

A second study conducted by the Banque de France provides another highlight on financial
constraint (Planes et al., 2002). Data from SESSI-CIS2 (French manufacturing firms) and
INSEE-CIS2 (French service sector firms) are paired with accounting and financial data from
the Banque de France (the sample includes 3453 firms). The innovative French firms which
suffered from a lack of financial resources when implementing innovative projects during the
period under review (1994-1996) have displayed, during the last decade (1992-1996), on
average, a more vulnerable balance sheet structure than the typical balance sheet structure of
the group of non-financially constrained firms. The rate of equity over financial debt is lower
for the first group - the group of innovative French firms which met financial obstacles - than
for the second one. The observed rate of interest is higher for the first group. Such firms, on
average, have a financial structure which does not send good signals to financial actors;
managers know that supplementary funds needed to finance innovative projects may be
rationed by capital suppliers either by limiting quantity or by raising the rate of interest.

This study brings out a new argument: financial constraints sustained by the group of French
firms with hampered innovation activity are explained not only by the ‘bad’ characteristics of
the projects but also by the corporate financial structure, as it indicates a higher risk of
bankruptcy. The ‘investment return on innovative project/economic risk’ pair is difficult to
assess, particularly for actors who are outside the firm. This difficulty, expressed by the
notion of asymmetry of information, can be partly circumvented by financial indicators drawn
from balance sheets and other significant accounting data. In this case, capital suppliers and
applicants share the same information, and both agree easily on what is a ‘good’ corporate
financial structure. Nevertheless, financial criteria based on balance sheets give a biased

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signal when used for screening innovative projects, as they are based on past corporate
performances.

The SESSI-CIS2 database adds a piece to the puzzle. By distinguishing between firms that
belong to a corporate group and independent firms, this database shows that small
independent firms are the less innovative group. Only 41 % of these firms succeeded with
innovative projects in 1994-1996, whereas 89 % of large firms linked with a corporate group
succeeded. Status adds something to the study of financial constraint, as this obstacle is more
important for independent firms than for non-independent. Therefore, it is possible to
conclude that small and independent French firms are in the most uncomfortable position for
obtaining external funds, an obstacle which limits the innovative capacity of this group.
However, such firms encounter various obstacles and lack of an appropriate source of finance
is not quoted as the most important, but only as one among the various hampering factors.

To sum up and conclude this part, with the exception of the U. K., the financial obstacle is
never the most important one and plays a relatively minor role when a project is seriously
delayed. Understanding of financial obstacles improves when the financial constraint is not
analysed only as an exogenous factor – a ‘myopic gatekeeper’ - which hampers innovative
activity and strategy. It is also directly linked with the quality of the project (cost, economic
and market risk) and with the corporate financial structure.

Part II Does the financial pattern of an innovative project replicate the

classical pattern?

Whatever the approach, either positive or normative, there is no consensus about the pattern
or, using Myer’s term, the ‘pecking order’ among the different financial sources which is or
should be followed to fund an innovative project. The basic results of the three theories which
are currently used as references for the analysis of financing innovative projects do not
converge (see Table I.4). However, they all share the idea that when agents fund an
innovative project, they in no way face an open choice, as is postulated in the Modigliani-
Miller approach, but a limited one, and they have preferences among the funding modes.

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Table I.4. Main predictions of economic theories, applied to the financing of innovation

Conclusions reached mechanism the financing of innovative projects

by the following
theories: relies on: does not rely on:

New investors may Cash flow capacity Equity capital raised

‘pecking order’ under-value corporate on financial market
(Myers, 1984) a projects as a
hierarchy is rationally consequence of
preferred by managers asymmetry of
and shareholders information

Specific assets are Lenders are reluctant Equity (either internal Debt (either from
financed by equity because specific or external) market or bank)
(O. Williamson, assets lose value in
1988) case of bankruptcy
Financial system Shareholders, being Equity capital raised Debt (either from
approach. residual claimants, on financial market or market or bank)
A market-based have an interest in invested by venture
system fits better investment with capital firms
uncertain return;
this is not the case for
lenders

The financial pattern of innovation issue can be highlighted by a French survey, called the
financing of innovative technology (FIT), which was conducted for this very purpose (box 2).
Evidence from the French database gives a good idea of the actual and virtual financial
pattern of innovative projects, not only on the French scale but at least for the continental
European countries.

Evidence from this survey validates the ‘pecking order’ theory. Table I.5 summarizes the
main results. Self-financing, using retained earnings, plays an overwhelmingly important role
(self-financing provides roughly three quarters of total financial resources invested in
innovative projects), debt is relatively unimportant and stock issuance is almost completely
unused. The high proportion of intra-group loans is worth remarking. Bank loans tend to fund
projects at downstream steps and are more often allocated to firms that are not intensively
innovative. Last but not least, financial resources from public agencies are important. It is the
second largest source (11. 2 %) and nearly one in two innovative firms have benefited from
this source (see table I.5 column 2). Public financing enables projects to get over the hurdle of
exploratory research and Research-Development (R&D): - the two steps during which the

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probability of abandonment is highest and future profitability is most uncertain. After these
two steps public funds are less and less solicited as the project progresses, while the firm gets
closer to normal operation and uncertainty decreases (Lhomme, 2001).

Table I.5. Sources of financing technologic innovation in 1999

% of total % of firms using

resources this resource *
Self-financing 73.8 85.1
Debt (extra-group) 6.4 34.2
. bank debt 4.6 32.4
. market (bond) 0.3 0.7
. intra-group debt 7.4 8.9
Public funds 11.2 47.0
. subsidies 4.6 NA
Equity issuing 1.1 4.5
Total 100.0
* number of firms having used this financial source to fund an innovative project, as a percentage of the total
number of innovative firms in the sample, in 1998 or 1999, in %.
Sources: FIT survey, SESSI

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 Box 2
Financing of technologic innovation (FIT) is a survey carried out by ESSI during the year
2000 among manufacturing industries with 20 and more employees. The survey focused on
the financial resources used for funding innovative projects in 1998-1999. A questionnaire
was sent to 5500 French firms, either innovative or not, and the rate of response approximates
70 %. When corporate innovative activity is crucial (marginal), the quality of the sample is
good (second-rate). A firm is classified as an innovative one if it has acquired products or
processes that are technologically new, for it or for the market, during the last three years. 5
steps in project advancement are distinguished: exploratory research, R&D, preparation for
industrial and commercial launch, industrialisation/manufacture, and marketing.
The quality of the answers to this survey, also, is a matter of debate. For some highly
innovative projects in new technology, the project did not start on a precise date, and was not
carried out as a plan perfectly well-defined from the start. Strategic decisions may change
during the course of the innovative activity, alliances and agreements with competitors may
be signed as a way to reduce R&D costs. For instance, evaluating accurately the total cost of 3
G mobile design, for a company like Alcatel, would require a specific investigation. Besides,
the idea that all expenses might be estimated for such an innovation conflicts with the
academic view of innovation as a complex process which includes tacit knowledge, spin-offs
from other innovative programs and so on.

The FIT survey includes a set of questions about the preferred financial pattern of innovative
projects, according to the project step. Firms were asked to indicate their preferred non-
alternative mode(s): self-financing, public funds, debt, equity issuance. At the upstream steps,
the twofold sources are overwhelmingly preferred: self-financing and public funds; at the
downstream steps, self-financing is always preferred by a large majority while preference for
public funds decreases, as managers know that this kind of fund is allocated to the early steps.

Evidence from the FIT survey and comments from the SESSI study (Lhomme, 2001) support
the following remarks about the preferred financial pattern:
1. Self-financing is preferred because uncertainty about the capacity to implement a profitable
innovative project is less intensive inside the enterprise. Insiders are in a better position to
assess the consequences of risky investments. In economic terms, information is not
asymmetric and the cost of self-financing resources is mainly an opportunity cost.

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2. Intra-group loans are preferred for the same reasons. Investors are also insiders; hence they
are in a better position than outsiders to evaluate the stakes of innovative projects. Loan
decisions are strategic, and innovative projects funded by the mother or holding company are
selected not only for economic reasons (profitability) but also because of the spin-offs for the
company from successful innovative projects. As shareholders, these entities participate in the
gains of innovative projects. Information costs are low and, in most cases, the risk premium
does not reflect the economic risk.
3. Public funding has specific advantages. The role of public funds in financing innovation is
explained by the specificities of R&D activity. At this step, uncertainty surrounding the
project’s technological feasibility is high, so that failure risk is high, while the social return of
R&D exceeds the private return even if it does lead to a profitable new product. Strategic
consequences, such as national competitiveness, are also at stake. Information costs may be
high, but the rate of interest is low, if not zero. Furthermore, availability of public funds has a
multiplier effect that is important for SMEs, sending bankers a signal of good quality, as
public agencies have a specific capacity to assess innovative projects.
Sources of funds numbers 2 and 3 can be grouped in the first circle, the circle of initiated and
competent actors whose expectations are not limited to the profitability of the project. These
actors allocate funds at an attractive cost because their interest in innovative projects is not
(only) financial.
4. Bank loans have no relative advantage. For current activity, banks have private information
on their customers which gives them an advantage (Fama, 1984) but this information is of
little interest in the case of innovative projects. Because of the nature of the debt contract, the
return of a loan, whatever the profitability of the project, is limited. Hence, bank loans are
costly, and the sources of cost are numerous: information, contract drafting, collateral, rate of
interest including risk premiums. Costs depend on the nature of the relationship between the
bank and the enterprise, and decrease in the case of a commitment relationship (as opposed to
an arm’s length relationship). In France banks customarily fix limited risk premiums, so that
rationing is rather a question of quantity, as predicted by economic theory. Bank loans can be
categorised in the second circle of financial sources, used as a complementary source when
conditions for entering the first circle are not met.
5. Bond issuance is rather a virtual source in Europe. Advantages/disadvantages depend on
the activity of financial analysts, which provides signals to market investors. Bond issuance
costs are prohibitive for SMEs.

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6. Public offering displays a set of specific features, because of the anonymous and non-
contractual nature of the relationship. It provides the possibility of raising a large amount of
money. However, it is very rare for a company to make a public offering with the explicit
purpose of funding an innovative project. In such a case, it is very likely that ‘new
shareholders’ will offer a price which under-values the project. Furthermore, stock issue is
costly and risky if the market is unstable.
The role of venture capital does not stand out, insofar as the survey did not cover firms with
less than 20 employees, this financial source can be classified in the first circle.

The preferred financial pattern suggested by the FIT survey is very different from the
Schumpeterian view, which is still influential in the economic literature on innovation.
According to Schumpeter’s early work, the success of entrepreneurs implementing new
technology requires that anonymous bankers operating like a Central Bank open their gates,
providing capital to newcomers. We are also a long way from the Modigliani-Miller concept
of investment decisions, where, firstly, a project is selected and, secondly, financial means are
allocated, the choice of financial resources being open and without influence on the physical
investment decision. Of course, for a small independent firm, entrepreneurs do not enjoy an
open choice, while this view is too narrow for a large incumbent firm with a wide array of
financing modes. Corporate financial decisions must take into account the need to maintain a
wide choice in the future. The question of the financing of innovation must not be addressed
strictly from the viewpoint of the need for wider choice and access to external resources,
coming from banks and/or markets. It must include the necessity for an innovative firm to
have financing readily available in the future, because the project may be more costly than
expected and because new opportunities may appear. For an innovative firm, it is necessary to
ease the actual as well the potential financial constraint, by keeping liquidity or having an
easy access to liquidity, now and in the future.

Part III The new technology firms: capital scarcity or excess?

New technologies are knowledge-intensive and highly risky. One key element in their
development is a new group of enterprises, called technology based small firms (TBSF). In
many new technology industries, TBSFs, like pilotfish, are linked, more or less tightly, with
public research and with large incumbent companies which orientate them towards innovative

17
activity. For these newcomers, financial constraints are so intensive, due to the lack of self-
financing capacity, that capital needs are often supplied by a specific financial actor: venture
capital. Because of the high rate of newcomers in industries based on new technologies,
financing plays an important role in the development of these new technologies.

Evidence concerning the weight of financial constraints on European new technology based
firms comes from CIS2. Unfortunately, this survey is only valid for one emblematic new
technology industry, computer services. The frequency of obstacles listed by European
computer service firms in CIS2 corroborates our expectations. If the project has not even
started, the financial obstacle is at the forefront (table A. 3), quoted by a large majority of
firms (more than eight out of ten in the U. K.). This survey testifies, if needed, to the
difficulties encountered by this new technology based sector in accessing financial resources.
If the innovative project comes up against serious delay, then the financial obstacle plays a
smaller role, the lack of human resources being the determining obstacle. It is certainly
appropriate to speak of the scarcity of highly skilled labour in the new technology industries,
but can we also speak of the scarcity of financial means? We must be cautious in answering
this question, as there is a thin line between capital scarcity and excess.

This third part aims to answer the following question: 1) do the new technology firms suffer
from capital scarcity or excess? The answer focuses, firstly, on the demand side, illustrated by
two industries, the biotechnology and Internet firms (III.1), secondly, on the supply side,
highlighting the role of banks, as this is less clearly identified than the market role (III. 2).?
Answering this question is, of course, not easy. Difficulties come from the lack of quantitative
databases which would provide information for a wide variety of firms operating in industries
identified as ‘New Economy’. To examine the main financial characteristics of New Economy
firms of all sizes and statuses, a corporate financial database collected at the sector level by
Central Bank, if available, is more suitable than a database covering only public companies,
especially in European countries 2. But because many of the New economy companies were
set up recently and sector classification is inadequate to deal with new technologies, it is
almost impossible to conduct analyses based on financial data on either a comparative level or

2
For the US, publicly traded companies are more representative of the whole industry than in Europe(see
Antoniewicz, 2001 for a study of the financial pattern of new technology based and publicly traded firms in the
US).

18
an historical level. And there is another handicap: the rapidly changing nature of new
technology based firms makes it difficult to draw up a stable financial pattern.

III.1 In the new economy, risk is amplified and financing requirements are high

To answer the question of capital scarcity versus excess we must begin by defining these
notions. Economists speak of capital scarcity when innovative activity is hampered by a lack
of funds, because capital suppliers have over-estimated the economic risk and/or are risk
adverse. Economists speak of excess of capital when investors have under-estimated the risk,
as they are sensitive to ‘mood markets’ and/or are risk lovers. If capital is misallocated on a
large scale, being invested in unviable firms or projects, this may entail systemic risk – the
whole financial system is put in danger – and crowd-out effects which are negative for other
industries or agents.

As a first step, it is necessary to explain why the uncertainty conveyed by New Technologies
is so particularly high, and, as a consequence, why economic risk is highly sensitive to under-
or overestimation. It is well known that an innovative project faces different kinds of risk,
depending on the step reached in the process. At upstream steps, uncertainty comes from the
possibility of transforming an idea or hypothesis into a design or prototype; at the middle of
the process, risk relates to the capacity to change a prototype into a large scale product; at
downstream steps, risk comes from the reaction of potential customers and the gap between
the anticipated market growth rate and the effective one. The ‘new economy’ adds an extra
element, as competition between newcomers and/or incumbent firms is intensive, in a winner-
takes-all world. Risk is amplified in such a competitive environment. Two new technology
based industries - Internet and biotechnology - illustrate how risk and financing requirements
correlate.

The Internet industry

The Internet industry is, indeed, a good illustration of an excess of optimistic anticipations
and over-accumulation of capital. A study analysing the performance of Internet start-ups
established in France in 1999 highlights the fact that many of the companies failed to generate

19
operating profits (38 % of the 125 companies in the sample had negative profitability, before
interest expenses), while almost a sixth had negative own funds. Besides, assets often provide
little guarantee to investors, as a third of these assets consist in holdings in similar companies,
with the same weaknesses in terms of solvency. One of the striking findings of this study is
the long-term need for external financing of a sub-set of start-ups whose recurring losses
entail a massive consumption of the funds they receive (Duvivier, 2000 a). Marketing and
advertising expenditures are permanently needed to boost market share, a major investors’
goal, and a high rate of R&D expenses is required to keep pace with innovation. This means
that these ‘launching’ expenses are recurring, becoming fixed costs and growing whereas in
traditional sectors they become variable and reducible costs (Duvivier, 2000 b). The economic
conditions in which Internet companies are developing are not independent of the financial
conditions; unviable firms are backed by over-optimistic investors. Over-investment results in
too many firms operating on the market. The Internet-related firms industry embodies this
situation.

The biotechnology industry

The biotechnology industry is another problematic case. It has given birth to some success
stories with extremely high return, but on the whole biotechnology-based firms are not
profitable. The size of R&D expenditure per unit of annual sales is a striking feature of
biotechnology companies (Table A. 4 and A. 5 in appendix). This ratio (which ranges from 70
% to 45 % in the US and Europe) illustrates the lengthy nature of the R&D phase on the one
hand and the lack of revenues on the other. On average, biotechnology companies analysed
each year by Ernst and Young have negative profitability, with negative net income, whatever
the region and the year. According to the main business models of this industry, companies
will become profitable once their discoveries have resulted in the marketing of products or if
the royalties on the patents they hold can generate substantial revenue. This raises questions
about the valuation of these new economy firms, especially in the light of losses accumulated
by this new industry since its birth. Investment decisions are based on growth potential,
analysed via the quality of the team, rather than on default risk. In the case of biotechnology,
investors, on the whole, behave as ‘risk-lovers’. However, the financial position of
biotechnology start-ups must also be seen in connection with the innovative activity strategy
of the large pharmaceutical companies. Incumbent and large companies tend to out-source

20
their R&D expenses by handing it over the start-ups. The level of R&D expenditure is far
greater for biotechnology companies than for pharmaceutical ones (Dubocage, 1999). This
‘division of skilled labour’ enables the latter to limit economic risk, as it is partially
transferred to the biotechnology industry.

Table III.1 presents some stylised features, which characterise either the biotechnology
industry or internet-related firms.

Table III.1 Risk, financing requirement, return in a winner-takes-all competition

Human assets are Labour costs are The breakeven point High fixed costs rate
central fixed, is high and difficult favours potential
Fixed costs are high to reach monopoly situation
and associated with and high potential
intangible assets return

High anticipated
return favours a
large flow of
newcomers, large
investment per firm
and over-
accumulation of
capital

Labour costs and Critical mass In this winner-takes-

entry costs (like increases with the all race, start-ups
advertisement costs) recurrent arrival of bankruptcy is costly
are ‘sunk’ costs newcomers for investors

Financial assets Value of financial Signals from

contribution to total assets is uncertain financial accounts
assets is high, with a are unclear
high proportion of
assets in firms
operating in the
same sector
(customer …)

Fixed costs (in relation to variable costs) are comparatively high in new economy firms. This
feature has distinct consequences. The relative weight of fixed costs is a factor, which favours
monopoly situations and may lead to high future earnings. High fixed costs stimulate the race

21
for dominant position which is a factor of instability at micro- and macro-levels. At the level
of the firm, significant financial resources are required to reach critical mass and resist
competition, not to mention leadership; these financial resources are irrecoverable (‘sunk’) in
case of corporate failure. At the sector level, equilibrium between supply and demand of
capital is unlikely to be reached. During the course of the same year, under-investment can
replace over-investment. In sectors like e-commerce, there is only room for a very limited
number of viable firms; nevertheless, at the beginning of the race, well-informed investors are
ready to bet on a newcomer if this newcomer is expected to win the race. Over-investment
stops with the failure of the riskiest companies, and then investors and lenders are tempted to
reduce finance flows to all companies, whether they are promising or not. Divestment and
capital rationing precipitate the bankruptcy of firms, which suffer from a lack of liquidity.

To boost market shares on the Internet market or to win the race in the biotechnology
industry, being the first firm to patent a discovery, the size of critical mass and, hence, the
financing requirement to cover losses are continually increasing. In the economic model of
start-ups, the breakeven point is higher than expected, as illustrated, for example, by the
difficulties encountered by Amazon.com to break even or by Genset, a start-up specialised in
the sequencing of the human genome, quoted on the Nasdaq and the French new market,
which, over more than twelve years, has never been profitable. These atypical cases are
supported by investors, whose expectations are over-optimistic and highly sensitive to market
opinion.

III. 2. Banks, like financial markets, can be over-optimistic

It is well-known that financial markets, because of the presence of over-optimistic investors,

have a tendency to over-evaluate the return of new and promising technologies, by under-
evaluating expenses. This is illustrated by the European railways bond market in the 19th
century. The role of banks in speculative waves is less clear. Because of the high degree of
uncertainty surrounding the capacity of TBSFs to reimburse loans, and the difficulties banks
have in evaluating this capacity, bank loan is assumed to play a very limited role during the
first stages of TBSF development (called the seed and start-up stages), whereas the expansion
stage, reached when the firm has become profitable, may entail greater use of bank financing.
Yet, in recent years, boundaries between the different phases and financing sources have

22
become increasingly blurred (Banque de France, 2002). Some firms resort to bank loans at a
relatively early stage and, during the financial bubble on technology stocks, banks were
tempted to change their attitude towards risk. The study of French Internet start-up financial
accounts in 1999 and 2000 illustrates this change (Duvivier, 2000 b). A striking finding is the
extent to which these TBSFs relied on bank loans in 2000, credit lines having swelled
dramatically during the previous twelve months (from 35 million euros to 100 million euros).
Although the sums involved remain small, this finding is worth noting. It appears to
contradict the predictions of finance theory, while providing a good illustration of mimetic
behaviour. Indeed, the new role of banks in this industry can be explained by the conjunction
of supply and demand factors: 1) banks have not developed specific skills to evaluate the
quality of TBSFs, hence bank decisions are influenced by the behaviour of other bankers,
following a mimetic process; in 2000, this sector looked promising to less well-informed
investors, who did not realise that the competitive race entails a high consumption of capital
to cover recurring losses; 2) venture-capital, being better informed, were disengaging and,
since the stock market correction of March-April 2000, sources of equity financing have dried
up, so that banks have taken over from venture capital and financial market as a source of
funding, bank financing becoming a forced choice for entrepreneurs. This story illustrates the
fact that, because of the disengagement of investors in the first circle and the entrance of
capital suppliers in the second circle, the financial pattern of TBSFs is exposed to rapid
changes. Under certain circumstances, a financial actor who used to play a minor role may
become important when firms have a low self-financing capacity.

When new technology is implemented by incumbent firms - also called firms of the ‘old
economy’ -, bank behaviour is different. The distrust of TBSFs that characterises banks on the
whole has no reason to persist when dealing with large firms of the old economy. If these
latter operate in a mixed sector (new and more traditional technology), such as
telecommunications, innovation is seen as a necessity for remaining profitable and such firms
can usually choose between different sources of financing, as long as their credit-worthiness
is good. However, financing needs have led telecom operators to borrow heavily from banks
and markets. In 2000, the telecom sector (operators and equipment manufacturers) attracted
30 % of loans granted worldwide through banking syndications. Some telecom firms, like
France Telecom and Deutsche Telekom, have also resorted to equity financing, following
privatisation. The actual high level of indebtedness of the telecom sector raises the question of
the crowding-out of other sectors and the question of the pricing of UMTS licences, as the

23
price paid by operators has been linked with the easy access to external financing. Telecom
indebtedness illustrates the double face of new technology financing: capital scarcity is
expected because of the high degree of uncertainty surrounding the return of new products,
and yet because evaluation of the anticipated return and economic risk is highly tricky,
investors’ decisions are influenced by biased signals and by other investors’ choices so that
capital scarcity can turn into over-accumulation, as illustrated by the unreasonably high P/E
(price to earning) ratios in some new economy sectors, or by the unreasonably high rate of
indebtedness of France Telecom.

Conclusion

Corporate managers face financial constraints when they decide to launch an innovative
project. This is a finding of the Community Innovation Survey. Many firms, in some cases a
majority, indicate that they have faced financial obstacles that hampered their innovation
activity. This paper has investigated the nature of these financial constraints, using CIS2.
Financial constraints can be exogenous - enforced by investors acting as ‘myopic gatekeepers’
- or endogenous. Endogenous constraints are based on fundamental variables, which are
economic when they relate to the risky and costly nature of the innovative project, or financial
when they relate to the corporate financial structure. What is the nature of the financial
constraints on innovative projects? Are they better explained by ‘fundamental’ variables or by
the behaviour of badly-informed actors, subject to market mood and to short-term
anticipations? The evidence provided by CIS2 favours the explanation of fundamental
determinants. This finding is not surprising when it is associated with the outcome of another
survey, conducted on a sample of French firms: innovative projects are mostly funded by self-
financing, public funding and intra-group loans, whereas bank loans are often marginal.
Consequently, difficulties raised by the asymmetry of information between capital suppliers
and demanders are not acute.

With new technology industry start-ups, the context changes: self-financing is not available,
uncertainty surrounding the return of a project is extremely high, evaluation of the quality of a
firm is a difficult task and investment decisions depend on unusual criteria. Hence, capital
suppliers can behave as ‘myopic gatekeepers’, not allocating capital to a promising project
because they cannot discriminate between good and bad ones, this behaviour being the rule in

24
the industry. This explains why bank loans contribute very little to the funding of the majority
of new technology industries. However, a wave of radically new innovations can also give
rise to over-optimistic and contagious expectations, and investors, attracted by growth
potentiality rather than by failure risk, can become risk-lovers, as demonstrated by the
speculative bubble on New Economy stocks. The story of French Internet start-ups and, of
course, the actual rate of indebtedness of telecom operators prove that banks can also behave
like financial market investors.

Because evaluating the quality of TBSFs is so very tricky, investors’ decisions are sensitive to
prevailing opinion, and the state of affairs can rapidly move from capital scarcity to over-
investment in firms which are high capital consumers, due to their difficulties in breaking
even. Recently, the erratic fluctuations on new high-tech markets have brought into question
the role of the financial market and the need for the regulation of initial public offerings. The
issue raised by financial constraints on innovation must not be approached solely from the
viewpoint of the need for financial systems based on markets (because they are more
conducive to technological development): the need for financial stability must also be taken
into consideration.

25
Bibliography

Antoniewicz R. L., « Financing of Publicly traded New Economy Firms in the United States »,
Federal Reserve Board draft paper, April 2001.

Banque de France (2002), Financing New Economy Firms, Banque de France Bulletin Digest, n° 98,
pp. 19-34.

Dubocage E. (1999), « The financing of innovation by venture capital in Europe and in the USA : a
comparative and sectoral approach », ESSY-TSER, European Commission, doc. mimeo.

Duvivier A. (2000 a), Start-up internet : premier diagnostic, Banquemagazine, 619, pp. 38-41.

Duvivier A. (2000 b), Financing and risks of Internet start-ups, a preliminary assessment, doc. mimeo,
Banque de France, unpublished

Lhomme Y. (2001), Financement de l’innovation technologique, Rapport 2001 de la Commission

permanente de concertation pour l’industrie (CPCI), Paris, pp. 159-176.

Myers S. C. (1984), « The Capital Structure Puzzle », The Journal of Finance, vol 39.3, pp. 575-592.

Planes B., Bardos M, Sevestre P., Avouyi-Dovi S., (2001), Innovation : financing and financing
constraints, doc. mimeo, 30 p.

Williamson O. E. (1988), « Corporate Finance and Corporate Governance », The Journal of Finance,
vol 43.3, pp. 567-91.

26
 Appendix 1: Methodological note about CIS2

The second Community Innovation Survey (CIS2) was launched in the EEC member states in 1997/1998. The
first Community Innovation Survey collected information for the year 1992. As a whole, results from the two
surveys are not directly comparable. All the participating countries have agreed on a common methodology and
a core questionnaire aimed at providing comparable, harmonised and representative data on a pan-European
scale. The survey is based on the Oslo-Manual. The reference year for the survey is 1996 for most countries.

The target population

The statistical unit is the enterprise, defined as the smallest combination of legal units that is an organisational
unit producing goods or services. The following activities have been included in the target population:
- all manufacturing industries
- service sectors
In Italy, the survey was only conducted for manufacturing industries.
The threshold is 20 employees in the manufacturing sector and 10 employees in the service sector.

The factors hampering innovation

The following list of explanatory factors has been given:
- Excessive perceived economic risks
- Innovation costs too high
- Lack of appropriate sources of finance
- Organisational rigidities within the enterprise
- Lack of qualified personnel
- Lack of information on technology
- Lack of information on markets
- Insufficient flexibility of regulations or standards
- Lack of customer responsiveness to new goods or services
The Italian answers to the question about factors hampering innovation are substantially lower than in any other
country

Classification of economic activities:

Manufacturing Industry

- Intermediate goods: manufacture of coke, refined petroleum products and nuclear fuel, manufacture of
chemicals, chemical products and man-made fibres.

- Equipment goods: manufacture of machinery and equipment

Services
- Transports: land transport; transport via pipelines; water transport; air transport
- Telecommunications
- Financial intermediation
- Computer and related activities

27
Table A.1 Percentage of innovative firms % with hampered innovative projects and
total

U. K. France Germany Netherlands Finland Italy

. seriously 27.4 54.8 37.8 35.0 46.5 6.5
delayed
. abandoned 12.1 20.1 17.5 22.5 13.4 4.9
. not yet started 39.7 24.6 26.8 20.8 12.9 21.9
Total innovative 38399 20032 81751 10785 1864 22748
firms

Sources: CIS2

Table A. 2. The rank of the financial factor among the hampering factors for innovating
enterprises, with abandoned projects and by size class

United-Kingdom France Germany Netherlands Finland Italy

Total manufacturing 2 4 6 6 6 3

Small enterprises 2 3 6 6 n.a. 3

Medium enterprises 2 4 7 9 5* 4
Large enterprises 3 5 6 7 6* 3

Total services 3 3 1* 9

Small enterprises 1* 2 1* 7
Medium enterprises 5* 3 5* 9
Large enterprises 5* 4 4* 8
Total 2 3 4 7

* indicates that for 1 or 2 factors there is no answer

NA indicates that the number of factors without answer is superior to 2, so that the rank of the financial obstacle
cannot be accurately determined.

Sources: Own calculations, CIS2

28
Table A. 3. The main obstacles listed by firms having a not even started innovation
project (% of firms having quoted the obstacle and rank estimated by the frequency of
answers)
Computer services Total activity

France % Rank % rank

Financial obstacle 28.0 3 24.8 3
Economic risk 28.4 2 35.1 1
Innovation cost 33.8 1 32.1 2
lack of qualified personnel 12.5 7 19.4 4
gap between the financial obstacle 5.8 10.3
and the first listed obstacle

Germany % rank % rank

Financial obstacle 62.6 1 38.9 2
Economic risk 54.4 2 46.5 1
Innovation cost n. a. n. a. 33.1 3
lack of qualified personnel 23.8 3 18.0 5
gap between the financial obstacle 0 7.6
and the first listed obstacle

The Netherlands % rank * % rank **

Financial obstacle 36.8 2 31.5 3
Economic risk 28.1 4 47.0 1
Innovation cost 32.5 3 44.4 2
lack of qualified personnel 42.1 1 30.5 4
gap between the financial obstacle 5.3 15.5
and the first listed obstacle

The U. K. % rank ** % rank **

Financial obstacle 85.7 1 58.5 1
Economic risk 12.6 2 37.5 2
Innovation cost 2.7 6 27.3 6
lack of qualified personnel 12.6 2 36.5 3
* data is not available for one question

** data is not available for two questions

Sources; Own calculations, CIS2

29
Table A.4 The financial characteristics of European biotechnology firms

2000-2001* 1998 1997

R&D / 56,3 % 62.9 % 70.1 %
Annual sales
Net income / - 8,1 % - 56.8 % - 74.1 %
Annual sales
Net income / - 14,3 % - 90.2 % - 105.7 %
R&D
Number of 1,879 1,178 1,036
Companies
(public) (104) ( 68) ( 61)
Employees 34,180 45,823 39,045

Source: Ernst & Young, European Life Sciences 1999 (2000), Global biotechnology at a glance (2002).
* data from 1 October 2000 to 30 September 2001

Table A.5. The financial characteristics of American biotechnology firms

2000-2001* 1998 1997

R&D / 45.5 % 53.2 % 52.8 %
Annual sales
Net income / - 19.0 % - 27.4 % - 21.1 %
Annual sales
Net income / - 41.6 % - 51.5 % - 40 %
R&D
Number of 1,457 1,283 1,274
Companies
( public) (342) (327) (317)
Employees 141,000 153,000 140,000

Source: Ernst & Young, European Life Sciences 1999 (2000), Global biotechnology at a glance (2002).
*data from 1 October 2000 to 30 September 2001

30