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t 200
3

1he Iinancing of R&D and Innovation
Bronwyn l. lall and Josh Lerner

J. Introduction
It is a widely held iew that research and deelopment ,R&D, and innoatie actiities are
diicult to inance in a reely competitie market place. Support or this iew in the orm o
economic-theoretic modeling is not diicult to ind and probably begins with the classic articles o
Nelson ,1959, and Arrow ,1962,, although the idea itsel was alluded to by Schumpeter ,1942,.
1
1he
main argument goes as ollows: the primary output o resources deoted to inention is the
knowledge o how to make new goods and serices, and this knowledge is nonrial: use by one irm
does not preclude its use by another. 1o the extent that knowledge cannot be kept secret, the
returns to the inestment in knowledge cannot be appropriated by the irm undertaking the
inestment, and thereore such irms will be reluctant to inest, leading to the underproision o
R&D inestment in the economy.
Since the time when this argument was ully articulated by Arrow, it has o course been
deeloped, tested, modiied, and extended in many ways. lor example, Lein et al ,198, and
Mansield et al ,1981,, using surey eidence, ound that imitating a new inention in a
manuacturing irm was not ree, but could cost as much as ity to seenty-ie per cent o the cost
o the original inention. 1his act will mitigate but not eliminate the underinestment problem.
Lmpirical support or the basic point made by Arrow concerning the positie externalities created
by research is widespread, mostly in the orm o studies that document a social return to R&D that

1
See, or example, ootnote 1, Chapter VIII o Capitati.v, ociati.v ava Devocrac,.
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4
is higher than the priate leel ,Griliches, 1992, lall, 1996,. Recently, a large number o authors led
by Romer ,1986, hae produced models o endogenous macro-economic growth that are built on
the increasing returns principle implied by Arrow`s argument that one person`s use o knowledge
does not diminish its utility to another ,Aghion and lowitt, 199,.
1his line o reasoning is already widely used by policymakers to justiy such interentions as
the intellectual property system, goernment support o R&D, R&D tax incenties, and the
encouragement o research partnerships o arious kinds. In general, these incentie programs can
be warranted een when the irm or indiidual undertaking the research is the same as the entity that
inances it. loweer, Arrow`s inluential paper also contains another reason or underinestment in
R&D, again one which was oreshadowed by Schumpeter and which has been addressed by
subsequent researchers in economics and inance: the argument that an additional gap exists
between the priate rate o return and the cost o capital when the innoation inestor and inancier
are dierent entities.
1his chapter concerns itsel with this second aspect o the market ailure or R&D and other
inestments in innoation: een i problems associated with incomplete appropriability o the
returns to R&D are soled using intellectual property protection, subsidies, or tax incenties, it may
still be diicult or costly to inance such inestments using capital rom sources external to the irm
or entrepreneur. 1hat is, there is oten a wedge, sometimes large, between the rate o return required
by an entrepreneur inesting his own unds and that required by external inestors. By this
argument, unless an inentor is already wealthy, or irms already proitable, some innoations will
ail to be proided purely because the cost o external capital is too high, een when they would pass
the priate returns hurdle i unds were aailable at a normal interest rate.
In the ollowing, we begin by describing some o the unique eatures o R&D inestment.
1hen we discuss the arious theoretical arguments why external inance or R&D might be more
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5
expensie that internal inance, going on to reiew the empirical eidence on the alidity o this
hypothesis and the solutions that hae been deeloped and adopted by the market and some
goernments, in particular the enture capital solution. Although we ocus our attention on R&D in
the irst three sections o the paper, much o what we discuss will apply to innoation inestment
more broadly deined. loweer, or reasons o data aailibility and measurement the empirical
literature has largely ocused on R&D spending, at least up until now. 1he chapter concludes with a
discussion o policy options.
2. Research and development as investment
lrom the perspectie o inestment theory, R&D has a number o characteristics that make
it dierent rom ordinary inestment. lirst and most importantly, in practice ity per cent or more
o R&D spending is the wages and salaries o highly educated scientists and engineers. 1heir eorts
create an intangible asset, the irm`s knowledge base, rom which proits in uture years will be
generated. 1o the extent that this knowledge is tacit rather than codiied, it is embedded in the
human capital o the irm`s employees, and is thereore lost i they leae or are ired.
1his act has an important implication or the conduct o R&D inestment. Because part o
the resource base o the irm itsel disappears when such workers leae or are ired and because
projects oten take a long time between conception and commercialization, irms tend to smooth
their R&D spending oer time, in order to aoid haing to lay o knowledge workers. 1his implies
that R&D spending at the irm leel usually behaes as though it has high adjustment costs ,lall,
Griliches, and lausman, 1986, Lach and Schankerman, 1988,, with two consequences, one
substantie and one that aects empirical work in this area. lirst, the equilibrium required rate o
return to R&D may be quite high simply to coer the adjustment costs. Second, and related to the
irst, is that it will be diicult to measure the impact o changes in the costs o capital, because such
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6
eects can be weak in the short run due to the sluggish response o R&D to any changes in its cost.
J. Brown and Petersen ,2009, oer direct eidence that U. S. irms relied heaily on cash reseres to
smooth R&D spending during the 1998-2002 boom and bust in stock market returns.
A second important eature o R&D inestment is the degree o uncertainty associated with
its output. 1his uncertainty tends to be greatest at the beginning o a research program or project,
which implies that an optimal R&D strategy has an options-like character and should not really be
analyzed in a static ramework. R&D projects with small probabilities o great success in the uture
may be worth continuing een i they do not pass an expected rate o return test. 1he uncertainty
here can be extreme and not a simple matter o a well-speciied distribution with a mean and
ariance. 1here is eidence, such as that in Scherer ,1998,, that the distribution o proits rom
innoation sometimes has a Paretian character where the ariance does not exist. \hen this is the
case, standard risk-adjustment methods will not work well.
In spite o the problems suggested by the nature o uncertainty in this area, the starting point
or the analysis o R&D inestment inancing has been the neo-classical marginal proit condition,
suitably modiied to take the special eatures o R&D into account. lollowing the ormulation in
lall and Van Reenen ,2000,, we deine the user cost o R&D inestment as the pre-tax real rate o
return on a marginal inestment that is required to earn a return r ater ,corporate, tax. 1he irm
inests to the point where the marginal product o R&D capital equals :

= = + +

1
, , ,
1
a c
R R
. .
MPK r p p M.C ,1,
. is the corporate tax rate, is the ,economic, depreciation rate, the term in p
R
is the relatie
appreciation or depreciation o R&D capital, and M.C is the marginal adjustment cost.
In this equation, .
a
and .
c
are the present discounted alue o deprecation allowances and
tax credits respectiely. In most inancial accounting systems, including those used by major OLCD
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economies, R&D is expensed as it is incurred rather than capitalized and depreciated, which means
that the lietime o the inestment or accounting purposes is much shorter than the economic lie
o the asset created and that .
a
is simply equal to . or tax-paying irms. Many countries hae a orm
o tax credit or R&D, either incremental or otherwise, and this will be relected in a positie alue
or .
c
.
2
Note that when .
c
is zero, the corporate tax rate does not enter into the marginal R&D
decision, because o the ull deductability o R&D.
1he user cost ormulation aboe directs attention to the ollowing determinants o R&D
inancing:
1. tax treatment such as tax credits, which are clearly amenable to interention by policy
makers.
2. economic depreciation , which in the case o R&D is more properly termed obsolesence.
1his quantity is sensitie to the realized rate o technical change in the industry, which is in
turn determined by such things as competition, market structure and the rate o imitation.
1hus it is inappropriate to treat as an inariant parameter in this setting.
3. the marginal costs o adjusting the leel o the R&D program.
4. the inestor`s required rate o return r.
1he last item has been the subject o considerable theoretical and empirical interest, on the
part o both industrial organization and corporate inance economists. 1wo broad strands o
inestigation can be obsered: one ocuses on the role o asymmetric inormation and moral hazard
in raising the required rate o return abe that normally used or conentional inestment, and the
latter on the requirements o dierent sources o inancing and their diering tax treatments or the
rate o return. 1he next section o the paper discusses these actors.

2
See lall and Van Reenen ,2000, or details. lor example, during the past three decades the US has had an incremental
R&D tax credit with a alue or .
c
o about 0.13 at the time o writing.
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39
this eect to quality certiication by the goernment that enables the irm to raise unds rom
priate sources as well.
14

A series o papers by Czarnitzki and co-authors ,Aerts and Czarnitzki, 2003, Almus and
Czarnitzki, 2004, Czarnitzki and lussinger, 2006, hae looked at the perormance o irms that
receie public R&D subsidies in seeral Luropean countries such as Belgium and Germany, using
treatment eect analysis. 1hey generally ind that such subsidies do not completely displace priate
expenditure on R&D ,that is, they are aaaitiovat, and that they are productie in the sense that they
result in patenting by the irm. lall and Maioli ,2008, surey a similar set o results or large Latin
American economies and reach a more nuanced conclusion.
6. Conclusions
Based on the literature sureyed here, what do we know about the costs o inancing R&D
inestments and the possibility that some kind o market ailure exists in this area Seeral main
points emerge:
lirst, there is airly clear eidence, based on theory, sureys, and empirical estimation, that
small and startup irms in R&D-intensie industries ace a higher cost o capital than their larger
competitors and than irms in other industries. In addition to compelling theoretical arguments and
empirical eidence, the mere existence o the VC industry and the act that it is concentrated
precisely where these startups are most actie suggests that this is so. 1he act that ex post enture
returns may lag the market, howeer, remains a puzzle and makes a clear-cut conclusion more
complex.

14
Also see Spiack ,2001, or urther studies o such programs, including Luropean studies, and Daid, lall, and 1oole
,2000, and Klette, Moen, and Griliches Klette ,2000, or sureys o the ealuation o goernment R&D programs in
general.
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40
Second, the eidence or a inancing gap or large and established R&D irms is harder to
establish. It is certainly the case that these irms preer to use internally generated unds or
inancing inestment, but less clear that there is an argument or interention, beyond the aorable
tax treatment that currently exists in many countries.
15

1hird, the VC solution to the problem o inancing innoation has its limits: lirst, it does
tend to ocus only on a ew sectors at a time, and to make inestment with a minimum size that is
too large or startups in some ields. Second, good perormance o the VC sector requires a thick
market in small and new irm stocks ,such as NASDAQ, in order to proide an exit strategy or
early stage inestors. Introducing a VC sector into an economy where it is not already present is
nontriial as it requires the presence o at least three interacting institutions: inestors, experienced
enture und managers, and a market or IPOs.
lourth, the eectieness o goernment incubators, seed unding, loan guarantees, and other
such policies or unding R&D deseres urther study, ideally in an experimental or quasi-
experimental setting. In particular, studying the cross-country ariation in the perormance o such
programs would be desirable, because the outcomes may depend to a great extent on institutional
actors that are diicult to control or using data rom within a single country.
Based on the surey o the literature presented here, other areas o interest or uture
research appear to be worthwhile. A longstanding debate in the literature is oer the interaction
between corporate goernance and corporate inance and its impact on long term inestment,
including inestment in intangibles such as R&D. Although in principle one might hae thought that
inancial markets ocused on quarterly perormance, such as those in the Anglo-Saxon economies,

15
It is important to remind the reader o the premise o this paper: we are ocusing ovt, on the inancing gap arguments
or aorable treatment o R&D and ignoring ,or the present, the arguments based on R&D spilloers and externalities.
1here is good reason to beliee that the latter is a much more important consideration or large established irms,
especially i we wish those irms to undertake basic research that is close to industry but with unknown applications ,the
Bell Labs model,.
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41
would discourage such inestment, this appears not to be the case, at least in the United States.
loweer, or seeral large Luropean countries, we hae limited eidence that the required rate o
return to R&D inestment is perhaps somewhat lower than in the U.S. and the U.K., especially
when the irm has a large majority shareholder ,see the lall, Mairesse, and Mohnen chapter, this
olume,. 1his act suggests that or these irms at least, the stability proided by concentrated
ownership may encourage R&D. At the same time, the more luid inancial markets with actie
markets or corporate control seem to be better at inancing new entrants, startups, and more oerall
inestment in innoation. 1he uture challenge is to understand more completely the interaction o
inancial market discipline with arious orms o corporate goernance and how this inluences the
organization and perormance o innoation.