Factors Driving The Search For Financing of Innovations
Jesper Gelderman S2541793 MSc Strategic Innovation Management
University of Groningen Faculty of Economics and Business
Supervisor: Prof. dr. D. L. M. Faems Co-assessor: A.A Oleksiak
August 2018
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ABSTRACT
This paper examines organizational characteristics that drive the search for external financing for innovation. Building on earlier literature on innovation and finance, hypotheses are developed. A field study was conducted involving 249 SMEs in the northern part of the Netherlands in order to test the conceptual model. Results show that the search for external financing for innovation tends to be driven by internal financial resource constraints, radical creativity and internal R&D investments. Furthermore, SMEs that are small or invest a lot of financial resources in internal R&D are more likely to experience these resource constraints. Regarding radical creativity, results show a surprising negative effect on the lack of internal financial resources. Also, when this lack of internal financial resources in the innovation process is included in the model as mediating variable, the effects of radical creativity on the search for external financing become more outspoken. This research adds to the research stream of financing innovation by exploring factors that drive the search for external financing for innovation and explain finance-seeking behavior.
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INTRODUCTION
The paper explores factors driving the search for external financing of innovations and the mediating role of a lack of internal financial resources. Innovation is widely regarded as a critical source of competitive advantage, especially in increasingly changing environments (Dess & Picken, 2000; Tushman & O’Reilly, 1996). Therefore, small and medium-sized enterprises (SMEs) must continuously innovate, as creativity and the innovation that may follow have become increasingly important factors in firm performance and long-term survival (Anderson et al., 2014).
Literature on finance identified two main concepts in the finance of SMEs, the internal and external forms of finance (Gélinas, 1998; Pretorius & Shaw, 2004). Early research argued that the capital market is imperfect, referring to the informational asymmetry among lenders and borrowers (Schumpeter, 1939; Hubbard, 1998). Because of these imperfections, internal financing has many cost advantages over external financing (Hall, 2002; Brown et al., 2009), therefore stimulating firms to rely on internal financing.
Even though the literature on financing and innovation is rich, the field of financing innovations is still underdeveloped (Hall & Rosenberg, 2010) and most studies seem to study finance in general, rather than financing innovation in particular (Padilla – Ospilla et al., 2018). Research by Gilbert et al. (2014: 197) suggested that financial resources are needed to support critical research and development (R&D) and innovation activities. R&D activities are considered to be a critical input to innovation and growth (Brown et al., 2009). Therefore, access to either external or internal financing for R&D is a key determinant of business development and performance for SMEs, as they allow firms to engage in innovation processes (Eniola & Entebang, 2015; Mazzucato & Semieniuk, 2017). However, external financing for SMEs involves greater risk, higher monitoring costs and it is more difficult to assess the viability of a project or technology compared to larger firms (Freel, 2000). Innovation and R&D projects in particular are difficult to finance externally, because these projects reinforce the risks and information asymmetry problems with external investors (Myers & Majluf, 1984; Jensen & Meckling, 1976; Hall, 2002).
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Schumpeter, 1939; Hubbard, 1988), external financial resources are also a key ingredient for growth and performce for SMEs (Fischer & Reuber, 2003). External financing could mitigate internal financing constraints and increase innovation and growth, implying that firms may need to seek financial resources externally. Literature on the financing of innovations, however, mostly seems to focus on constraints in access to external finance and its effects on innovation performance. In order to experience constraints, firms must have been looking for external financing. While the constraints have often been examined, the factors driving the search for external financing for innovation have mostly been overlooked (Xiang & Worthington, 2015), even though the need to examine this was described a long time ago (Romano et al., 2001). By treating the search for external financing as a dependent variable, rather than an independent or moderating one, this paper aims to contribute to literature by empirically examining reasons why some SMEs are more likely to search for external finance than others. Building on this literature gap, I will examine the following research question:
RQ: What factors drive the search for external financing for innovation?
The aim of this paper is to provide a better understanding of how different organizational characteristics affect a possible lack of internal financial resources, therefore encouraging the search for external financing of innovation. More specifically, I will examine how firm size affects the search for ways to finance innovations. Smaller firms usually have less retained earnings, which could drive their search for external financing for innovation. Also, I will examine the role of organizational creativity. In doing so, I will distinguish between incremental and radical creativity. Since the development of radical ideas tends to be more costly, firms may be more likely to experience internal financial constraints and search for external financing of potential innovations. Another possible driver is the degree to which SMEs invest in R&D. Given the necessity of investments in R&D and innovation, SMEs that invest more in R&D may be more likely to search for external ways to finance this process if they are unable to finance the activities internally.
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Results show that a lack of internal financial resources in the innovation process is a main driver in the search for external financing for innovation. These financial constraints are mostly experienced by smaller firms or firms that invest a lot of financial resources in internal R&D activities. Furthermore, results confirm a direct positive relationships between radical creativity and investments in internal R&D and the likelihood of SMEs to seek external financing for innovation activities. Results do not confirm the expected mediating effects of the lack of internal financial resources in the relationship between the organizational characteristics and the search for external financing. However, the results show an interesting effect for radical creativity. While radical creativity directly leads to higher likelihood to search for financing, it also reduces the internal financial resource constraints for firms. When taking into account the role of the financial constraints, the direct effect of radical creativity on the search for financing for innovation becomes more outspoken. Finally, results show that small, young and family owned firms tend to have a greater need for subsidies rather than financing for innovation.
In the next section, the paper will present a literature review in which theoretical background will be provided and the hypotheses will be developed. The paper will examine how firm size, organizational creativity, internal and external R&D investments relate to the search for external financing for innovations through a lack of internal financial resources. After describing the research method, the empirical findings using data from 249 SMEs in Northern Netherlands from a wide range of industries will be presented. The paper will conclude with a discussion of theoretical and practical implications of the results as well as its limitations and suggestions for future research on the topic of financing innovations.
THEORETICAL BACKGROUND
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Financial Resource Constraints in Innovation
The abstract and subjective nature of the concept often has often challenged researchers to properly define and measure financial constraints. Financial constraints refer to the inability to raise the necessary amount to finance investment and growth (Kaplan & Zingales, 1997). This definition covers almost every firm and should therefore be most appropriate. The effects of financial constraints, or lack of access to finance, on R&D have been studied extensively. Originally, it was often thought that resource scarcity had a positive influence on innovation, because necessity could be a main driver of invention. Giddens (1984) pointed out the dual nature of financial constraints, claiming that it may also enable innovation in some way by creating a necessity to be creative.
Over the last decades, research and practice seem to have converged to the idea that financial resources are the key driver of the innovation performance (Gilbert et al., 2014). In doing so, research emphasized the need for financial resources in order to conduct critical R&D activities more effectively. The dominant logic here is that resource slack and a certain degree of freedom are necessary to enable innovation (Damanpour, 1991). Lack of financial resources may limit the degree of freedom and therefore hamper the innovation performance of SMEs. It is important to be cautious when seeking to understand how to cope with constraints and minimize the negative effects on innovation, because it may overshadow the perspective in which constraints may actually enhance innovation (Gilbert et al., 2014).
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External Finance of R&D
The relationship and differences between internal and external financing have often been discussed in earlier literature. Internal financing relates to the available financial resources inside the organization, usually consisting of cash flows and retained earnings (Fazzari et al., 1988). In contrary, external financing relates to the availability of external financial resources, which may either be debt or equity financing by externally interested parties on the market, such as outside investors (Coase, 1937).
The previous section explained the role of financial resources and constraints in innovation and R&D processes. Many firms experience an internal lack of financial resources. Beck et al. (2006) argued that access to external financing may mitigate this lack of financial resources and enhance growth of most SMEs. However, in a comprehensive study of the financing of R&D, Hall (2002) argued that investments in R&D activities are different and more complex than other types of investments. As a result, R&D activities are commonly seen to be difficult to finance in a freely competitive market.
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Although early literature on finance research encourages firms to rely on internal financial resources for R&D, recent studies imply that external financial resources may also be critical input into the innovation and R&D processes. Many SMEs seek external financing for innovation in order to overcome the lack of internal financial resources (Beck et al., 2006; Fischer & Reuber, 2003), implying that the greater costs of external financing do not hold them back in obtaining external financing for innovation and growth.
Public and Private Sources of Financing
Even though many firms use internal sources of financing, Fischer and Reuber (2003) found that external resources may also be a key ingredient for growth and performce for SMEs. Literature has mainly recognized two main types of financing, namely public and private financing. Public financing typically relates to government investments into innovation, often with the purpose of fixing, making or shaping markets (Mazzucato, 2013). Lazonick and Mazzucato (2013) consider these investments as the backbone of most successful innovations. In contrary, private finance involves all investments of private financial actors, such as investment companies or friends and family.
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HYPOTHESES DEVELOPMENT
In this section, I will explain and hypothesize the underlying relationships between the concepts. At first, the direct effects of the independent variables will be explained. Subsequently, I will hypothesize and elaborate on the relationships depicted in figure 1. Direct Effects on Search for External Financing for Innovation
External financing obviously has benefits that go beyond the injection of financial capital into the R&D processes. For smaller firms, investors want to reduce the risks as well and obtain the highest possible return on their investments. They may provide the smaller firms in the sample with advice and help in order to exploit the invested financial capital as much as possible. Therefore, firm size may be directly and negatively related to the likelihood of SMEs to search for external finance.
Furthermore, research has shown that financing has a stronger and more significant effect on the outcomes of the development of radical ideas compared to the effects on ideas for incremental innovations (Beck et al., 2016). Based on this, I assume that innovative SMEs with radical creativity have more incentives to search for financing than SMEs who have more incremental creatvitiy. Therefore, I expect radical creativity of SMEs to be positively related to the likelihood of SMEs to search for external financial resources to develop radical ideas for innovation. Similarly, I expect incremental creativity to be negatively related to the search for external financing for innovation. Considering the limited effect on the outcomes of ideas for incremental innovation and the cost disadvantages of external financing, SMEs with incremental creativity may be more likely to finance innovation projects internally.
Regarding the R&D expenditures, I expect a positive relationship between internal and external R&D investments and the search for external financial resources. SMEs invest in R&D to build competitive advantage and increase operational performance (Lev et al, 2005). Firms may possess the necessary internal financial resources for R&D activities and still decide to seek external financing, because they prefer to save their cashflows and retained earnings for future investments decisions that may potentially be more valuable to the firm.
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Effects on the Internal Financial Resource Constraints
Research has shown that self-raised finance, through cash flows or retained earnings, is the main source of finance for smaller firms. This is mostly explained by the constraints in access to external financing (Freel; 2000, Du & Girma, 2012). The relationship between firm size and financial performance has been studied multiple times, and many studies have shown positive effects of firm size on the financial performance. Some studies found positive effects because of higher returns on assets (e.g. Nehring et al., 2009), while others highlight higher returns on sales (Garcia-Fuentes et al., 2013). The underlying logic in the positive relationship between firm size and profitability is that larger firms have greater market and resource opportunities, enabling economies of scale (Lopez-Valeiraz et al., 2016). Since smaller firms generally produce lower cash flows and less retained earnings than large firms, they may experience more trouble raising the necessary internal financial resources for growth and innovation. Based on this reasoning, this paper will examine the following hypothesis:
H1: Firm size (in FTE) is negatively related to the lack of internal financial resources in innovation processes.
Figure 1 Conceptual Model
Control Variables: Age, Family Firm, & Industry Dummies
Incremental Creativity Radical Creativity Lack of Internal Financial Resources Internal R&D Investments Firm Size - - External R&D Investments
Search for External Financing Innovation +
+
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Another potential driver in the search for external financing is organizational creativity. In this research, I will distinguish between incremental and radical creativity in order to find out whether they drive the search for external financing differently. It is important to recognize that the purpose of this distinction is not to suggest that one type of creativity is necessarily superior to the other, but to explore whether they have different effects on a perceived lack of internal financial resources, thereby possible affecting the search for external ways to finance the R&D and innovation processes.
Radical creativity refers the generation of highly novel ideas that tend to break away from the dominant logic (Woodman et al., 1993), or substantial deviations from existing practices (Dewar & Dutton, 1986). Meanwhile, incremental creativity relates to small changes and minor modifications to existing products and practices (Madjar et al., 2011). R&D activities are critical in generating, developing and applying these creative ideas (Leenders et al., 2003). One of the most important differences between incremental and radical creativity is the cost of change for the organization that develops the potential innovation (Ettlie et al., 1984). Compared to incremental innovations, the development of radical ideas for innovation is more likely to require new capabilities or technologies that are not available yet to the firm and need to be acquired or developed. It becomes obvious that radical creativity involves more risks and requires strong resource commitment, including financial resources (Cromer et al., 2011). Early research already argued that the capital investments required for an innovation may inhibit SMEs to engage in the innovation and R&D processes (Rothwell, 1978). In other words, the development of innovations that follow from radical creativity tends to be more costly than innovations that may follow from incremental creativity. When SMEs are not able to raise the needed financial resources for growth and innovation internally through cashflows or retained earnings, they are constrained in their innovation activities due to a lack of internal financial resources. Following these arguments, I expect to see both types of creativity affect the possible lack of internal financial resources in different ways. SMEs could experience more difficulties raising the needed financial resources internally for radical creativity than for incremental creativity. This leads to the following hypotheses to be tested:
H2: Incremental Creativity is negatively related to the lack of internal financial resources in innovation processes
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I will also distinguish between investments in internal and external R&D activities. The relationship between internal R&D expenditures and financial capital has been studied extensively. Investments in capital and R&D largely relate with the internal financing for smaller firms (Ughetto, 2008; Brown et al., 2009).
According to Himmelberg and Petersen (1994), there are studies that found no relationship between R&D and internal finance. However, these studies only considered large firms. These firms typically have greater cash flows than the R&D activities require. This is in line with findings by Hao and Jaffe (1993), who argued that R&D tends to be liquidity constrained. Again, this conclusion was aimed at the smaller firms and did not hold for some large firms with excessive cash flows. However, since I am investigating SMEs, I assume that these are also more likely to be financially constrained.
One potential problem is that volatile profits create an undesired instability for the R&D activities, because these often require stable and smooth investment paths. In a volatile business cycle, the internal R&D activities may be financially constrained at some points (Ughetto, 2008). Possibly the most prevalent problem that SMEs face is that economically and socially desirable opportunities may arise that require more financial resources than the firms are able to obtain from cash flows and existing profits (Ughetto, 2008). Since the internal financing was defined as the ability to raise the needed financial resources internally through cash flows or retained earnings, SMEs that need to invest in R&D in order to cope with the changing environment are more likely to experience a lack of these internal financial resources. Building on this reasoning, the following hypothesis will be tested:
H4: SMEs that invest more in internal R&D activities are more likely to experience internal financial constraints in these activities.
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limitations of the internal R&D processes by gaining access to the economies of scale and scope available to other (research) organizations (Love & Roper, 2002). Therefore, it may be important for many SMEs to engage in these activities. This hypothesis follows the same reasoning as the previous one. SMEs that need to invest in external R&D activities in order to keep up with the changing environment, may not possess or generate the needed internal financial resources to do this. An additional argument stems from the increase in transaction costs (Williamson, 1979). External R&D activities require partnerships that need to be managed and coordinated effectively, which implies an increase in transaction costs (Love & Roper, 2002). Therefore, this paper will test the following hypothesis:
H5: SMEs that invest more in external R&D activities are more likely to experience internal financial constraints in these activities.
Lack of Internal Financial Resouces and Search for Finance
Early research on the relationship between internal and external financing proposed the pecking-order hypothesis (Myers, 1984; Myers & Majluf, 1984), implying an inverse relationship between the availability of internal financial resources and the use of external financing. According to this theory, firms tend to reduce the usage of external finance following an increase in internal financial resources. Following this theory, De Haan et al. (2003) studied the finance decisions of Dutch firms and found that the initial preference is to finance investment projects internally. This implies that SMEs tend to finance projects internally if it possible and usually consider external financing, despite its costs, when they are unable to finance projects through cash flows or retained earnings. In an influential article, Fazzari (1988) argued that the availability of internal funds or financial resources allows firms to undertake desired R&D and innovation projects without resorting to expensive external financing. Similarly, SMEs that were unable to raise the needed financial resources for the R&D and innovation activities internally, had to finance them externally in order to remain innovative. Following these findings, I will test if the lack of internal financial resources affects the search for external financial resources for innovation. This leads to the following hypothesis:
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Mediating effects of Internal Financial Resource Constraints
Following the literature on external financing, I argue that SMEs resort to external financing for innovation when they are unable to finance innovation processes internally. In other words, these SMEs are unable to finance innovation processes through cashflows or retained earnings. Following this reasoning, smaller firms are more likely to search for external finance, because they experience a lack of internal financial resources. Similarly, the expected negative direct relationship between incremental creativity and the search for external finance is mediated by the expectation that these firms are more likely to be able to finance these projects internally. In contrary, I expect the positive direct effect of radical creativity on the search for external finance to be explained by the possibility that SMEs cannot finance these more expensive projects internally. As shown in the final hypotheses, I expect that SMEs need to invest in R&D in order to keep up with the environment. They may not always be able to finance these activities internally, so they may need to resort to external financing for these activities. In short, I assume full mediating effects in the following hypotheses:
H7a: Lack of internal financial resouces mediates the negative relationship between firm size and the search for external financing for innovation.
H7b: Lack of internal financial resouces mediates the negative relationship between incremental creativity and the search for external financing for innovation.
H7c: Lack of internal financial resouces mediates the positive relationship between radical creativity and the search for external financing for innovation.
H7d: Lack of internal financial resouces mediates the positive relationship between internal R&D investments and the search for external financing for innovation.
H7e: Lack of internal financial resouces mediates the positive relationship between external R&D investments and the search for external financing for innovation.
METHODOLOGY
Procedure and Sample
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The research is part of the Innovation Monitor of SMEs in the northern part of the Netherlands. This is a cooperation between SNN and the University of Groningen to monitor and benchmark all the innovation activities and performances in the provinces of Drenthe, Friesland and Groningen. Firms have the opportunity to participate annually to see how their innovation performances have developed over the past years. The sample of firms covers a wide range of industries, most notable the service providing and the manufacturing sectors. It should be noted that these sectors offer very diverse services and goods. Sector such as ICT, wholesale and retail, construction, healthcare and accommodation are also well-represented. The distribution of industries in the sample that will be analyzed is depicted in figure 2.
The innovation monitor covers a wide range of topics with regard to innovation. Earlier innovation monitors have examined innovation topic, such as secrecy, R&D investments, cooperations and human capitalin order to find out how SMEs in the region score on these factors and what the implications are. This year, the innovation monitor has put more emphasis on the financing with regard to innovation activities. The aim of this paper is to find out whether SMEs have been searching for external ways to finance activities R&D and innovation and what drove them to make this decision. For this research, these new questions are relevant as they help to test the hypotheses.
The survey was send out to 5576 SMEs in total. Initially, they were invited by mail to participate in the survey, followed up by several reminders. Finally, potential respondents were contacted by phone in order to encourage them to participate. Respondents will receive a report on their innovation activities and performance, allowing them to compare the results
0 10 20 30 40 50 60 70 Other
Accommodation & Food Service Healthcare Construction ICT Wholesale & Retail Manufacturing Service Providers
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with their earlier results, but also with similar companies or possible competitors. A total of 503 representatives of SMEs responded substantially, which equals a response rate of roughly 9%. Of these respondents, 184 SMEs participated in the innovation monitor of last year as well. In order to test the hypotheses and maintain consistency, I will take into account the number of firms that answer all questions on relevant factors and variables. With 249 firms, this is a relatively large number that should provide generalizable and valid results.
Measurements
Search for External Financing The measure of the dependent variable, search for external financing for innovation, will be a nominal variable. Respondents answer whether they sought and/or applied for external ways to finance their innovation or R&D activities during the period 2015-2017. After recoding the variable, 1 will refer to “no” and 2 will refer to “yes”. Lack of Internal Financial Resources This variable is included as the mediating variable in the relationship between certain organizational characteristics and the search for external financing for innovation. Respondents answer to what extent a lack of financial resources in the SME itself has hinder the innovation activities during the period 2015-2017. After recoding the variable, possible answers range from 1) no constraint to 4) great constraint. Firm Size Size of the firm relates to the number of employees in full-time equivalents. The focus of the research is on SMEs, so the firms employ between 0 and 250 employees.
Radical and Incremental Creativity Even though multiple questions relate to organizational creativity, they are not necessarily related. Therefore, a principal component analysis (PCA) was conducted on the items related to organizational creativity. The analysis contains 249 cases. Even though 300 cases is regularly seen as comforting and good (Tabachnick & Fidell, 2007; Comrey & Lee, 1992), it should be sufficiently adequate. Since all communalities are well above .6, the amount of cases is sufficiently reliable (MacCallum et al., 1999).
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component in the data. Two components had eigenvalues over Kaiser’s (1960) criterion of 1 and in combination explained 80.11% of the variance. The factors that cluster on the same components indicate that factor 1 represents incremental creativity (Creativity_3, Creativity_4 and Creativity_6). The factors that cluster on component 2 represent radical creativity (Creativity_1, Creativity_2 and Creativity_5). The key results of the principal component analysis are shown in table 1 and 2 below.
Total Variance Explained Initial Eigenvalues
Component Total % of Variance Cumulative %
1 3,237 53,942 53,942 2 1,570 26,163 80,105 3 0,496 8,259 88,365 4 0,317 5,290 93,655 5 0,199 3,314 96,969 6 0,182 3,031 100,000
Table 1 Principal Component Analysis: Eigenvalues and Explained Variance
Rotated Component Component 1 2 Creativity_1 0,035 0,903 Creativity_2 0,120 0,927 Creativity_3 0,909 0,174 Creativity_4 0,898 0,186 Creativity_5 0,398 0,685 Creativity_6 0,885 0,080
Table 2 Principal Component Analysis: Rotated Component Matrix
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Incremental Creativity involves three different variables on which the answers range from 1) completely disagree to 5) completely agree. Measures for incremental creativity relate to the degree to which employees produce ideas for small adjustments in day-to-day business (Creativity_3), current procedures, processes and products (Creativity_4) and small improvements (Creativity_6). In order to measure the effects on the mediator and the dependent variable, the average of these three variables will be computed.
Radical Creativity also involves three variables on which answers range from 1) completely disagree to 5) completely agree. Respondents answer to which extent employees generate breakthrough ideas for entirely new procedures, processes and products (Creativity_1), ideas that implicate major changes in current practices, routines or way of thinking (Creativity_2) and ideas to do thing completely different in the future (Creativity_5). In order to measure the effects on the mediator and the dependent variable, the average of these three variables will be computed.
Investments in Internal R&D This variable or factor relates to the extent to which SMEs invest in internal R&D activities. Respondents answers how much they spent on internal R&D activities relative to their sales during 2017. They will be asked how much percent of sales volume has been invested in internal R&D activities.
Investments in External R&D This variable or factor relates to the extent to which SMEs invest in external R&D activities. Respondents answers how much they spent on external R&D activities relative to their sales during 2017. More specifically, it will refer to the percentage of sales volume invested in external R&D activities.
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Secondly, firm age will be included as control variable. In a recent study, Pellegrino (2018) found that younger firms experience more internal financial constraints in their innovation activities. Thus, they could be more likely to search for external ways to finance their innovation projects.
The other control variables will be related to the industry. Multiple studies examined and argued that industry has an important influence on financing patterns (Degryse et al., 2012; Caneghem & Campenhout, 2012). These variables will be operationalized with the use of dummy variables. The analysis will include variables for the three most represented industries and one for the remaining industries, based on the available SBI codes on the website of the Dutch Chamber of Commerce (Kamer van Koophandel, 2017). The first industry involves specialized service providers, such as consultancy or accountancy firms. All SMEs with an SBI code between 6910 and 7420 are coded as 1 (industry), while the other SMEs are coded as 0 (not industry). Secondly, a dummy variable will be made for the manufacturing industry. All SMEs with an SBI code between 1041 and 3312 will be coded as 1 (industry), while the other SMEs will be coded as 0 (not industry). The third industry involves wholesale, retail and car reparations. For this industry, all firm with an SBI code between 4611 and 4772 will be coded as 1 (industry) and the remaining firms will be coded as 0 (not industry). Finally, a dummy variable will be made for the remaining industries. All firms that do not operate in one of the aforementioned industries will be coded with 1 (industry), while the others will be coded with 0 (not industry).
RESULTS
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Descriptive Statistics
The total sample in the analysis consisted of 249 SMEs. Regarding the dependent variable, 135 SMEs had actually sought external financing for innovation, while the other 114 had not. Although not analysed, the data from the innovation monitor provides interesting information regarding the sources of external financing. Even though not all SMEs in the final sample had responded to these questions, it should provide an indication of where SMEs seek external finance. Most SMEs in the sample turned to the government for finance, while family, friends and banks were also moderately popular sources of external financing. Only few firms sought external financing via accountants, financial advisors or the Chamber of Commerce.
The descriptives also confirm that many SMEs experience internal financial constraints in their innovation activities. Almost a third of the sample responded with “great constraint” and another third experienced “moderate” internal financial constraints. This highlights the prevalence of the lack of internal financial resources among SMEs.
The industry dummies are not included in the correlation matrix presented in table 3 in order to maintain clarity. The sample contained 62 specialized service providers. Also, 59 SMEs from the manufacturing industry are included. It is important to point out that this is a relatively broad industry, with products ranging from food to chemicals. The wholesale, retail and car reparations sector consisted of 26 SMEs. The dummy involving the remaining industries consisted of 102 SMEs.
20 Des cri pti ves and Co rrel ati ons No V ari abl e Mea n S. D. 1 2 3 4 5 6 7 8 9 1 Sear ch for Ex tern al Fi nanc e 1. 54 0. 50 1 2 Lack of Inte rnal Fi nanc e 2. 71 1. 05 0. 267 *** 1 3 Fi rm Si ze 27. 24 43. 54 -. 091 -. 210 *** 1 4 Incre men tal Crea ti vi ty 4. 08 0. 65 -. 001 -. 094 .102 1 5 Rad ical Crea ti vi ty 3. 23 0. 92 .225 *** -. 040 -. 102 .359 *** 1 6 Internal R& D investm ents 16. 97 22. 89 0. 331 ** .204 *** -. 228 *** .040 .373 *** 1 7 Ex tern al R& D inves tme nts 4. 27 13. 88 .191 ** .107 * -. 134 ** -. 033 .153 ** .311 *** 1 8 Fi rm A ge 28. 31 31. 71 -. 141 ** .204 *** .369 *** .064 -. 189 *** -. 280 *** -. 156 ** 1 9 Fam ily Fi rm 1. 52 0. 50 -. 047 -. 032 .096 -. 025 .038 -. 106 * -. 175 *** .313 *** 1 N = 24 9, *p <0 .0 5, ** p <0 .0 5, *** p <0 ,0 1
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Direct Effects on the Search for External Financing
The analysis will follow the four steps proposed by Baron and Kenny (1986: 1176) on how to examine mediating effects. Building on these steps, I start with testing the direct effects of organizational factors (independent variables) on the search for external financing for innovation (dependent variable). Subsequently, the relationship between the organizational factors and the lack of internal financial resources (mediating variable) will be tested. Afterwards, I will test the effects of the lack of internal financial resources on the search for external financing for innovation. The final step will test for the possible mediating effect of the lack of internal financial resources in the relationships between organizational factors and the search for financing.
The first step of the model of Baron and Kenny (1986) is to test the relationship between organizational characteristics and the search for external financing for innovation. Even though these effects were not hypothesized, table 4 presents the analysis of the direct effects. The Nagelkerke R2 implies that the model predicts 21.2% of the variability in the search for external financing, the Cox and Snell R2 estimates this at 15.8%. Hosmer & Lemeshow’s goodness-of-fit test shows that the model fits the data with χ2
= 9.136, p = .331. Although I expected a direct negative relationship between firm size and the likelihood to search for external financing, results did not confirm this expectation.
Furthermore, a negative relationship between incremental creativity and the search for financing was expected. Again, results do not show a significant direct negative effect of incremental creativity on the likelihood to search for external finance in order to develop these ideas for incremental innovations. Results show support for the expected direct positive relationship between radical creativity and the search for external financing for innovation activities with B = .305, p < 0.10. This implies that when employees generate more ideas for radical innovations, the SMEs are more likely to search for external financing in order to develop these potential innovations.
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A test for multicollinearity was conducted in order to discover possible relations between predicting variables. In the model, multicollinearity is not an issue, as the results range from radical creativity (tolerance = .713; VIF = 1.402) to external R&D investments (tolerance = .869; VIF = 1.151)
Predictors Model 1 Model 2 Model 3
Independent variables
Firm Size .001(.003) .000 (.003)
Incremental Creativity -.234 (.231) -.232 (.236)
Radical Creativity .315 (.175)* .305 (.179)*
Internal R&D investments .034 (.010)*** .033 (.010)***
External R&D investments .033 (.020)* .031 (.020)
Control Variables Firm Age -.009 (.005)* -.001 (.005) Family Firm .056 (.276) .066 (.301) Dummy_Service -.541 (.334) -.386 (.362) Dummy_Manufacturing .537 (.340) -.473 (.370) Dummy_WholesaleRetailCar -.384 (.455) -.399 (.488)
R2 (Cox & Snell) .035 .151 .158
R2 (Nagelkerke) .047 .201 .212
Hosmer & Lemeshow 9.966 (p = .267) 8.669 (p = .371) 9.136 (p = .331)
Note: *p < 0,10, **p <0,05, *** p < 0,01
Table 4 Binary Logistics Regression: organizational factors affecting the search for external financing for innovation. The dummy for remaining industries is used as reference category.
Organizational Characteristics and Lack of Internal Financial Resources
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The most surprising result is the significant, but negative, relationship between radical creativity and the lack of internal financial resources. Building on earlier theory, I hypothesized that radical ideas for innovation are more costly to develop. Therefore, SMEs would feel financially constrained in their innovation activities. Table 5 shows a clear negative relationship between radical creativity and the lack of internal financial resources, with a standardized coefficient of -.146, p < .05. Thus, the results reject the third hypothesis. One possible explanation would be that previous radical creativity led to successful innovations, resulting in above average returns and cash flows. This would mean that radically creative SMEs may actually be able to finance innovation projects internally. The results show clear support for the fourth hypothesis with a standardized coefficient of .178, p <.05. However, for the fifth hypothesis, no significant relationship was found between external R&D investments and the lack of internal financial resources. In other words, firms investing in internal R&D are more likely to experience internal financial resource constraints in the R&D processes than firms investing in external R&D.
It should be pointed out that the R2 of this model with .108 is low, which means that only 10.8% percent of the variance in the dependent variable can be explained by the explanatory variables. Nevertheless, the model shows several significant relationships.
Predictors Model 1 Model 2 Model 3
Independent variables
Firm Size -.167 (.002)*** -.132 (.002)*
Incremental Creativity -.039 (.107) -.030 (.108)
Radical Creativity -.124 (.081)* -.146 .(083)**
Internal R&D investments .201 (.003)*** .178 (.003)**
External R&D investments .039 (.005) .041 (.005)
Control Variables Firm Age -.213 (.002)*** -.138 (.002)* Family Firm .043 (.140) .052 (.139) Dummy_ Manufacturing -.006 (.294) .010 (.195) Dummy_ WholesaleRetailCar -.062 (.248) -.068 (.245) Dummy_Other -.027 (.168) -.024 (.166) R2 .047 .089 .108 Adjusted R2 .07 .070 .071 F-value 2.395 ( p < .05) 4.743 ( p < .01) 2.895 ( p < .01) Note: *p < 0,10, **p <0,05, *** p < 0,01
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Lack of Financial Internal Resources and the Search for Financing for Innovation
The next step in the research is to test whether the lack of internal financial resources predicts the search for financing for external innovation. Table 6 shows the results of the binary logistic regression. These results show that the lack of internal financial resources is a significant and important predictor of the search for financing for innovation. In doing so, the results confirm my sixth hypothesis. The χ2 of the model with the mediator and the dependent variable is 7.989, with p = .435. Since the p-value is above the significance level, the predicted probabilities do not significantly deviate from the observed probabilities in a way that the binominal distribution does not predict. The Nagelkerke R2 implies that the model predicts 12.3% of the variability in the search for external financing for R&D or innovation, the Cox and Snell R2 estimates this at 9.2%. When controlling for firm age, family ownership and differences between industries, lack of internal financial resources significantly predicts the search for external financing for innovation with B = .507, p < 0.01. Earlier research suggested that firms finance projects internally before resorting to external financial resources (e.g. Myers, 1984). This research confirms that SMEs tend to start looking for external finance when they are unable to finance projects through retained earnings and cash flows.
The test for multicollinearity shows that relations between predictors are not an issue, as results range from the manufacturing dummy (tolerance = .627; VIF = 1.594) to internal financial resource constraints (tolerance = .953; VIF = 1.049).
Predictors Model 1 Model 2 Model 3
Mediating variable
Internal Financial Constraints .534 (.130)*** .507 (.134)***
Control Variables Firm Age -.009 (.005)* -.006 (.005) Family Firm .056 (.276) .111 (.285) Dummy_Service -.541 (.334) -.550 (.346) Dummy_Manufacturing -.537 (.340) -.549 (.351) Dummy_WholesaleRetailCar -.384 (.455) -.489 (.470)
R2 (Cox & Snell) .035 .070 .092
R2 (Nagelkerke) .047 .094 .123
Hosmer & Lemeshow 9.966 (p = .267) 3.158 (p = .206) 7.989 (p = .435)
Note: *p < .10, **p < .05, *** p < .01
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Mediating Effects of Lack of Internal Financial Resources
A variable can only function as a mediator when all of the three previous steps led to significant relationships (Baron & Kenny, 1986). The final step is to measure the aggregate impact of organizational characteristics and the lack of internal financial resources on the search for financing in order to find a mediating effect. When the effects of the organizational characteristics on the search for external finance substantially decrease after the mediator is controlled, it is possible to speak of a mediating role. Table 7 shows the results of this final step. The χ2 of the model with the mediator and the dependent variable is 3.567, with p = .894. The Nagelkerke R2 implies that the model predicts 27.4% of the variability in the search for financing, while the Cox and Snell R2 estimates this at 20.4%.
The analysis shows that the lack of internal financial resources does not mediate the relationship between firm size and the search for external financing for innovation, therefore rejecting hypothesis H7a. This does not come as a surprise, because the lack of a significant direct relationship between firm size and the likelihood to seek external financing makes a mediation effect impossible (Baron & Kenny, 1986).
The analysis shows that the lack of internal financial resources also cannot mediate the relationship between incremental creativity and the search for external financing. Given the insignificant relationship between incremental creativity and the internal financial resource constraints and the search for external financing of innovation, the model fails to establish the needed zero-order relationships between the variables. This makes mediation impossible (Baron & Kenny, 1986), therefore rejecting hypothesis H7b.
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Predictors Model 1 Model 2
Independent Variable
Firm Size .000 (.003) .002 (.003)
Incremental Creativity -.232 (.236) -.219 (.243)
Radical Creativity .305 (.179)* .423 (.189)**
Internal R&D Investments .033 (.010)*** .031 (.010)***
External R&D Investments .031 (.020) .032 (.019)*
Mediating variable
Internal Financial Constraints .502 (.135)***
Control Variables Firm Age -.001 (.005) -.005 (.005) Family Firm .066 (.301) .113 (.285) Dummy_Service -.386 (.362) -.545 (.346) Dummy_Manufacturing -.473 (.370) -.565 (.357) Dummy_WholesaleRetailCar -.399 (.488) -.490 (.471)
R2 (Cox & Snell) .158 .204
R2 (Nagelkerke) .212 .272
Hosmer & Lemeshow 9.136 (p = .331) 3.567 (p = .894)
Note: *p < .10, **p < .05, *** p < .01
Table 7 Binary Logistic Regression: mediating role of internal financial resources constraints on the relationship between organizational factors and the search for external financing for innovation (H7a-H7e).
Regarding hypothesis H7d, the results do not show a clear mediating role of the lack of internal financial resources. Results show significant relationships in all previous steps. After including the mediator, the effects of internal R&D investments on the likelihood that SMEs seek external financing for innovation decrease from B = .033, p < 0.01 to B = .031, p < 0.01. The decrease in the relationship is not substantial enough to speak of a clear mediation effect. Therefore, the hypothesis is rejected.
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Finally, I conducted another test for multicollinearity, including the lack of internal financial resources as predicting variable in the model. After including the mediating variable, there is again no multicollinearity in the model, as the results range from the manufacturing dummy (tolerance = .592; VIF = 1.688) to the lack of internal financial resources (tolerance = .892; VIF = 1.122).
Post Hoc Analysis
Although not hypothesized, an additional analysis was run with regard to the applications for grants or subsidies rather than the search for finance. Subsidies refers to support (mostly from governments) that encourages firms to carry out R&D activities by lowering the costs and reducing uncertainties associated with innovation (Carboni, 2011). With this analysis, I hope to explain why some SMEs did not seek external financing, even though they may lack internal financial resources. The post-hoc analysis was more straightforward than the main conceptual model. Considering the significance of the relationship between the lack of internal financial resources and the search for external financing in the conceptual model, the mediator was included as control variable in this analysis. The goal of this analysis was to find out if the certain factors were directly related to application for subsidies by SMEs.
The dependent variable in this analysis was the application for subsidies. SMEs replied to nine different forms of subsidies whether they 1) had actually heard from the subsidy, 2) had heard from it, but did not apply or 3) applied for the subsidy. Based on these responses, a nominal variable was created with SMEs who did not apply for any of the subsidies coded as 0, while SMEs that applied for one or more forms of subsidies were coded as 1. In total, 142 SMEs had applied for at least one type of subsidy, while 107 had not.
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contrary to internal R&D investments, investments in external R&D activities are not a significant predictor. This shows that firms investing in internal R&D are more likely to apply for subsidies than those investing more in external R&D. Other organizational characteristics do not significantly predict the application. It should be noted, however, that radical creativity is almost significant with B = .331, p = .11. This could be examined in future studies. Similar to the main conceptual model, incremental creativity is not a significant predictor of the dependent variable, implying that innovation processes for incremental innovations do not necessarily involve external financial resources through subsidies.
Regarding the control variables, the post-hoc analysis shows a significant relationship between firm age and the application for subsidies, with B = -.010, p < .10. In contrast, firm age did not significantly predict the search for external financing for innovation. This implies that younger firms may be more likely to apply for subsidies than to search for external financing. It is important to point out, however, that the relationship is not very strong and may therefore not play an important role. Furthermore, family firms also tend to have a greater need towards subsidies than to search for external financing with B = .855, p < .05. Interestingly, SMEs that experience internal lack of financial resources were not more likely to apply for subsidies. Regarding the industries, the manufacturing sector significantly predicted the application for subsidies. This implies that manufacturing firms tend to apply more for subsidies than firms in other sectors. A possible explanation could be that subsidies may be well-suited to the innovation needs of this sector.
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Predictors Model 1 Model 2 Model 3
Independent variables
Firm Size .013 (.004)*** .011 (.004)***
Incremental Creativity .303 (.255) .299 (.271)
Radical Creativity .306 (.191) .331 (.205)
Internal R&D investments .075 (.014)*** .073 (.015)***
External R&D investments -.001 (.014) .000 (.014)
Control Variables
Internal Financial Constraints -.121 (.133) -.214 (.161)
Firm Age -.013 (.005)*** -.010 (.006)*
Family Firm .675 (.293)** .855 (.355)**
Dummy_Service -.460 (.335) .313 (.205)
Dummy_Manufacturing -1.722 (.398)*** 1.641 (.455)***
Dummy_WholesaleRetailCar -.302 (.461) .449 (.530)
R2 (Cox & Snell) .114 .271 .337
R2 (Nagelkerke) .154 .363 .453
Hosmer & Lemeshow 10.402 (p = .238) 6.840 (p = .554) 8.537 ( p = .383)
Note: *p < 0,10, **p <0,05, *** p < 0,01
Table 8 Binary Logistic Regression; factors explaining application for subsidies. Dummy for remaining industries included as reference category.
DISCUSSION Summary of Results
The analysis shows that radical creativity, internal R&D investments and internal financial resource constraints are positively and directly related to the likelihood that SMEs seek external financing for innovation. However, no support was found for the direct effects of firm size, external R&D investments and incremental creativity on the search for finance.
Results also show that the lack of internal financial resources is mostly experienced by firms that are small or invest a lot in internal R&D. Incremental creativity and external R&D investments did not affect these resource constraints.
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Theoretical Implications
The field of financing for innovation integrates literature on innovation and finance. However, it is still relatively underdeveloped and immature (Hall & Rosenberg, 2010). According to a recent literature review (Padilla – Ospilla et al, 2018), an important problem of this research stream is that most papers seem to put too much emphasis on financing in general. Given the increasing importance of innovation in the current environment (Dess & Picken, 2000; Tushman & O’Reilly, 1996; Anderson et al, 2014) and the effects of internal financial constraints on the innovation (e.g. Freel, 2000; Gibbert et al, 2014; Laforet & Tann, 2006), further research in this field is necessary.
I contribute to literature by examining organizational characteristics that drive the search for external financing for innovation activities. Earlier research extensively examined the relationship between internal and external financing, emphasizing the cost advantages of internal financing over external financing (e.g. Schumpeter, 1939; Hubbard, 1998). Myers (1984) introduced the order-pecking theory, claiming that firms prefer to finance projects internally, before resorting to external financing. This paper contributes to this theory by providing empirical evidence that the inability to raise the needed financial resources internally through cash flows or retained earnings is an important driver in the search for external financing for innovation.
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In my research, I made the distinction between incremental and radical creativity in order to examine whether they affect the experience of internal financial constraints and the search for finance in different ways. I hypothesized that the development of ideas that result from radical creativity embody greater costs of change (Ettlie et al., 1984) and that SMEs may experience more trouble raising the needed financial resources in order to develop radical ideas than to develop ideas for incremental innovations. While no significant results were found for incremental creativity, the analysis shows that firms with high radical creativity are more likely to search for external financing for innovation. However, the analysis also presents a more surprising result, which is the negative relationship between radical creativity and the lack of internal financial resources, implicating that radical creativity reduces the internal financial resource constraints in the development of innovations. Freel (2000) recognized that SMEs enjoy several benefits with regard to innovation than the larger firms. For instance, they lack bureaucracy and often maintain informal, internal and most notably efficient communication systems. The nearness to the market allows them to be more flexible. In short, when SMEs develop the ideas that result from radical innovation, they tend to experience advantages. Possibly, this enabled SMEs to capture above average returns from previous radical creativity and the subsequent innovations. These earnings could have been retained, leading to a negative relationship between radical creativity and internal financial resource constraints.
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was not reduced enough to confirm a clear mediation effect. According to Baron and Kenny (1986), this indicates the presence of multiple mediation factors. In this research, I show that internal financial resource constraints is not one of these mediators, so future research may take a deeper look at the relationship between internal R&D investments and external finance.
Practical Implications
Results of this paper are mainly relevant for governments and institutions that are involved in external financing of SMEs. SMEs that seek external financing for their innovation activities mainly turn to governments and banks and people they know personally, rather than formal intermediaries, such as advisors or accountants.
When these actors are interested in investing in the innovation activities of SMEs, the results provide a clear overview of organizational factors that increase the likelihood that these SMEs seek external financial resources for their R&D activities. I show what types of SMEs these investors should target, namely those who generate ideas for radical innovations and invest a lot of financial resources in internal R&D activities. When targeting potential innovators, investors could look beyond industries, as differences between industries did not seem to predict the search for external financing. However, they should be careful when targeting SMEs that are small, young and family owned, as results indicate that these may to have a greater need for subsidies than for external financing. The aim of my paper was to develop a deeper understanding of why SMEs seek finance. Through a deeper understanding of organizational characteristics driving the search for external financing for innovation activities, governments and institutions may help to improve industry practice. They can enable development and growth through effective financing of innovative SMEs.
Limitations and Suggestions for Future Research
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The second limitation refers to the variable that measures the lack of internal financial resources. Earlier research (Silva & Carreira, 2011) pointed out that financial constraints are often subjective and in this case self-assessed. This could have led to biases, resulting from the individual’s perceptions.
Another important limitation is that the data of the innovation monitor does not allow this paper to distinguish between public and private financing of innovation. Both forms of external financing may affect R&D innovation in different ways (e.g. Mazzucato, 2013). Previous research showed that private finance is more focused on short-term returns on investments, while public finance tends to be more long-term oriented (e.g. Lazonick, 2013). Therefore, public finance has more potential to stimulate radical innovations, as SMEs get to spend more time developing their innovations (Janeway, 2012). This research argues that firms with ideas for radical innovations are more likely to search for external financing, implying that they may be turning to the public bodies for financial resources. Future research should empirically examine whether organizational characteristics, such as organizational creativity, drive the search towards either public or private financing.
Moreover, I conducted an additional analysis that compared the application for subsidies with the search for financing. This provided interesting findings that may be in contrast with the search for financing. Future research should dig deeper in the role of subsidies in order to stimulate innovation among SMEs and find out whether there may be a substitution effect with financing. Also, subsidies could be integrated in the order-pecking theory to see when firms prefer subsidies, internal or external finance.
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CONCLUDING REMARKS
This paper contributes to the literature field of the financing of innovations by empirically examining organizational factors that drive the decision to seek external financing. In doing so, I tested the effects of firm size, organizational creativity and R&D investments on the likelihood of SMEs to search for financing of innovations. Furthermore, I examined the role of internal financial resource constraints as mediator.
Looking back on the research question, results have shown that the search for external financing tends to be driven by radical creativity, internal R&D investments and the lack of internal financial resources for innovation. When the mediator is controlled, the effects of radical creativity on the likelihood that SMEs seek external financing for innovation actually become more outspoken.
Finally, the availability and accessibility of subsidies may play a role. When firms are small, young or family owned, they tend to have a greater need for subsidies than for external financing for innovation.
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