2019' Rui Zhang: How Financing Activities Affect Firm Innovation

2019' Rui Zhang

This paper focuses on analyzing how various financing activities affect firm innovation from five different perspectives. By reviewing existing studies of reputable researchers, I found out that each of the financing activities has its unique mechanisms in influencing a firm's ability to generate innovative outputs. The five different financing activities I select are CVC's development, hedge fund activism, stock liquidity, financial analyst coverage, and tolerance for failure.  In summary, we can find out that more of CVC's development, hedge fund intervention, and tolerance for failure motive innovation while less stock liquidity and coverage of financial analysts reach the same result.
Keywords: CVC, stock liquidity, firm innovation, hedge fund, analyst coverage
1. CVC and Firm Innovation 
In terms of innovation, Lerner (2012) suggests that the corporate venture capital (CVC) program could be the best way to promote innovation based on its combination of corporate research laboratories and venture-backed startups. There has been constant debate between the effect of CVC financing on the innovation productivity of entrepreneurial firms. Some people believe that CVCs could be superior in nurturing innovation compared to IVCs based on the following characteristics. First, CVCs have longer investment horizons than IVCs. Second, compared to IVCs, CVCs pursue both financial and strategic objectives. Third, CVC fund managers do not have a purely performance-driven compensation plan. Also, the unique knowledge of the industry and technology expertise of CVCs may enable them to assess and nurture their portfolio firms' development better( Chemmanur, Loutskina & Tian, 2014). Researchers mention that CVCs could be more likely to promote and motivate innovation based on these four characteristics compared to IVCs.
Chemmanur, Loutskina & Tian (2014) first compare the innovation output of initial public offering (IPO) firms backed by CVCs with those backed by IVCs. They use the data to construct two measures of innovation output: "the number of patents generated by a firm as our measure of the "quantity" of innovation, and the number of future citations received per patent as our measure of the impact or "quality" of innovation(Chemmanur, Loutskina & Tian, 2014)". The researchers found out that CVC backed firms produce more patents and especially patents generate with higher quality then IVC backed firms. To further rule out the possibility of CVCs' ability to nurture innovation as well as to identify and select entrepreneurial firms with higher innovation potential. Chemmanur, Loutskina & Tian (2014) further examine a sample consisting of the universe of VC-backed entrepreneurial firms. They match the VC-backed firms to the patent information based on entrepreneurial firm name and location. The researchers conduct the difference-in-differences (DiD) analysis to test the effect between VCs' first-round investments and their portfolio entrepreneurial firms' innovation output. They found out firms receive a more significant long-term increase in innovation output by obtaining their first-round financing from CVCs than IVCs (Chemmanur, Loutskina & Tian, 2014).  However, some people argue that CVCs might invest in more mature firms that are likely to promote innovation. The researchers dive further into the character of CVC and found out that "CVC-backed entrepreneurial firms are younger and riskier at the VC investment round date. They spend significantly more on R&D than IVC-backed firms (Chemmanur, Loutskina & Tian, 2014)." Hence, both findings reveal the fact that CVC-backed firms generate higher innovation output and thus promote innovation.
Furthermore, Chemmanur, Loutskina & Tian (2014) explore two mechanisms that lead to the fact that CVCs better motivate innovation then IVCs. First, they found that entrepreneurial firms that operate close to the industrial expertise of the CVC's parent company are more innovative based on the fact those entrepreneurial firms have better technological fit with their parent company and could be more likely to form a strategic alliance with them. As Robinson (2008) argues, "strategic alliances help overcome incentive problems and are more conducive to promoting risky innovation." Second, they found out failure tolerance is another important mechanism for CVCs to nurture innovation. According to Chemmanur, Loutskina & Tian (2014), they use the time that VCs allow their portfolio firms to succeed before stopping their investments as the measure of tolerance for failure. They found out that CVCs are more failure tolerant than IVCs and thus better nurture innovation than IVCs. This finding is also consistent with the conclusions of the previous section, meaning the higher failure tolerance, the better promotion of innovation.
2. Hedge Fund and Firm Innovation
People have debated continuously about the consequences of stock market pressure on managerial incentives to engage in long-term value-added innovative activities that are not easily assessed by the market. As Stein (1988,1989) indicates, the idea of this "managerial myopia" result from stock market pressure has been a big concern and lead investors to consider whether they have put too much pressure on corporate managers to chase short-term gains at the expense of long-term value creation (Bray et al., 2017).
Because it is hard for researchers to evaluate the long-term impact of hedge fund activism based on limited data and methodologies, therefore,  we can not merely conclude that activist investors are pursuing their short-term gains at the expense of a firm's long-term values. As Holmstrom (1989) addresses, "innovative activities involve the exploration of untested and unknown approaches that have a high probability of failure with contingencies that are impossible to foresee." This idea leads to the concern that management might choose not to take the risk and invest in long-term innovative projects under pressure to reach the near-term performance. Also, it is not clear whether management aligns their interests with the firm's long-term goal due to the agency problem. They may choose to under- or -over-invest based on their interest (Bray et al., 2017).
To find out how hedge fund activism affects firm innovation, Bray (2017) first examines "innovation activities at target firms before and after hedge fund intervention, measured by both inputs (R&D expenditures) and outputs (patent quantity and quality)." They found out innovation output -measured by patent counts and citation counts per patent increase drastically while R&D spending decreases dramatically in an absolute amount over the five-year window after hedge fund activism (Bray et al., 2017).  Furthermore, the researchers discovered four mechanisms that hedge fund used to reshape target firms. First, firms improve their patent quantity and quality as well as refocusing their efforts after the intervention of hedge fund activists from a diverse portfolio of patents. Moreover, firms reallocate their internal innovation technology to centralized core areas to improve their innovation efficiency (Bray et al., 2017). Second, "hedge fund intervention is followed by a more active and efficient reallocation of outputs from innovation (Bray et al., 2017)". Therefore, target firms manage to preserve patents that create critical value to the firm and sell those patents that less related to their technological expertise. In summary, patents sold post hedge fund intervention receive a higher number of citations, and a higher rate of patent transactions to new and better-suited owners represent efficient reallocation of innovation outputs (Bray et al., 2017).
The third mechanism refers to the redeployment of innovators at target firms following the intervention. Bray (2017) found out that "stayers at non-target firms are less productive than inventors retained by target firms; new employees are less productive than inventors who leave after hedge fund intervention; inventors hired post hedge fund intervention perform similar productivity at the new firm. Consequently, Bray (2017) reveals that the redeployment of human capital post-intervention motivates the key innovative personnel to be more productive and thus promote innovation efficiency.
The fourth mechanism introduces the idea that the average managerial incentives change in the post-intervention period tend to have more risk tolerance (Bray et al., 2017). For example, new and retained top executives get longer expected tenue; CEOs enjoy an increase of their share ownership; directors that hired post hedge fund activism tend to have better credentials and are more technology-focused.
In conclusion, Bray (2017) point out hedge fund intervention help firm to promote its innovation outputs (quantity and quality of patents) through better shifting firm's efforts towards its core expertise, better redeploying its innovative resources (patents and innovators), and better creating aligned incentive plans.
3. Financial Analyst Coverage and Firm Innovation
It is a big challenge for most firms to motivate innovation.  Existing studies point out, "firms that invest heavily in innovative projects might be forced to make only partial disclosure and be subject to a larger degree of information asymmetry" (Bhattacharya and Ritter, 1983). As a result, these firms are more likely to be underrated by equity holders and face a higher risk of hostile takeovers (Stein, 1988). Some people argue that financial analysts might be an excellent solution to deal with this investment problem caused by information asymmetry. They point out that financial analysts can gather sufficient information and data to present accurate reports that represent the real value of the company's innovative projects. Based on this thought, He and Tian (2013) propose two competing hypotheses to test out whether financial analysts help to motivate or impede innovation.
The first hypothesis is in support of the mainstream argument that financial analysts can encourage firm innovation by reducing the information asymmetry of innovative firms (He and Tian, 2013).  The second hypothesis makes the opposite prediction. As Manso (2011) addresses, it is necessary to tolerate failure to motivate and nurture innovation. However, financial analysts tend to focus on short-term forecasts and tend to "punish" firms who make short-term failures. Taken together, He and Tian (2013) proposed the hypothesis that financial analysts impede firm innovation by imposing short-term pressure on managers.
He and Tian (2013) use the observable innovation outputs (i.e., the number of patents granted to a firm) to assess the success of long-term investments in innovation, and the baseline tests reveal a negative relation between analyst coverage and innovation outputs. The researchers then use two different strategies to establish the causality of the baseline test.
Their first strategy is to "rely on two plausible quasi-natural experiments, brokerage closures (Kelly and Ljungqvist, 2011, 2012) and brokerage mergers (Hong and Kacperczyk, 2010)". They make firms whose analyst coverage decreases due to brokerage closure or mergers as the treatment group, while the similar firms whose analyst coverage remains the same as the control group (He and Tian, 2013). They found out a relatively more substantial increase in innovation output results from a decrease in analyst coverage for the treatment group compared with the control group in the following years by using a difference-in-differences (DiD) approach (He and Tian, 2013). Also, He and Tian (2013) use the second strategy to construct a two-stage least squares(2SLS) analysis to test the effect between analyst coverage and firm innovation. They reach the same result, which indicates that analyst coverage has a negative causal impact on corporate innovation.
Furthermore, He and Tian (2013) indicate that four potential mechanisms might help us to understand this negative relationship. First, a reduction in analyst coverage leads to a change in institutional ownership. On the one hand, it increases the ownership of dedicated investors who serve as a shield against short-term pressure and motivate innovation (Aghion, Van Reenen, and Zingales, 2013). On the other hand, it decreases the ownership of non-dedicated investors who focus on short-term financial returns. Second, a reduction in analyst coverage leads to a decrease in the firm's exposure to takeovers, and thus lower the manager's short-term pressure and motivate them to take innovative projects (Stein, 1988). Third, He and Tian (2013) found out that stock illiquidity and accrual-based earnings management practices can protect managers from being pushed to meet short-term targets and help to nurture innovation.
In conclusion, He and Tian (2013) examine the effect of analyst coverage by testing two competing hypotheses and found out that the more significant number of analysts a firm is covered, the fewer patents they can generate. They used two identification methods to examine the baseline test further and found out that a negative relationship exists between analyst coverage and firm innovation, meaning analysts bring much pressure to managers to meet short-term returns and impede the firm's long-term innovation.
4. Stock Liquidity and Firm Innovation 
According to Porter (1992), competitive advantage is one of the crucial elements for a nation's business to compete effectively in the international market. In this way, substantial investment has to be invested in the business and make them continuously innovate and improve their competitive advantages. Talking about the importance of innovation, Fang raise the thought to test the effect of stock liquidity on firm innovation.
Researchers suggest that two reasons might lead to the distortion of stock liquidity to innovation. First, under the takeover pressure, managers are likely to be forced to sacrifice long-term performance, such as to invest in long-term innovative projects to chase near-term profits and prevent the stock from being underrated (Stein, 1988,1989). Shleifer and Summers (1988) also reveal that managers have less incentive to invest in long-term innovation projects when hostile takeover threats are high. In short, Fang (2013) indicate that higher liquidity would most likely increase the chance of a hostile takeover attempt so that the takeover pressure can force managers to avoid investing in long-term projects that motivate innovation.  Second, as Porter (1992) emphasizes, high liquidity facilitates entry and exit of institutional investors whose only trade depends on current earnings. These actions bring more noise to the market and lead to the undervaluation of innovative projects. According to Bushee (2001), a group of institutional investors tends to invest heavily in firms with higher near-term earnings. Moreover, managerial myopia is widely existing among corporate managers. In the survey findings in Graham, Harvey, and Rajgopal (2005), CFOs suggests that they are willing to meet short-term earnings targets to help maintain firms' stock price by scarifying long-term sustainability.
On the other hand, some researchers believe that stock liquidity may promote corporate innovation because of liquidity functions as the entry of blockholders (Maug, 1998). Manso (2011) indicates that "blockholders can discipline managers when managerial compensation is closely tied to stock price." Fang (2013) also mentions that stock prices could be more efficient when blockholders collect private information and trade on this information. Therefore, managers might be willing to prioritize their investments in long-term innovative projects when high liquidity leads to better monitoring or more efficient prices (Fang, Tian & Tice, 2013).
According to Fang (2013), it is difficult to test the effect between stock liquidity and innovation because both variables could affect each other simultaneously. Then researchers use a difference-in-difference approach to run the test to break this simultaneity and "conduct tests during periods surrounding shocks to liquidity such as decimalization and other regulatory changes in the minimum tick size" (Fang, Tian & Tice, 2013).
First, the researchers document a positive relationship between innovation output and stock illiquidity. Then they conduct three identification tests to establish the causality between innovation output and stock illiquidity by using the same DiD method. Fang (2013) found out all of their three identification tests suggest that stock liquidity has a negative causal effect on corporate innovation. Moreover, the researchers discover possible mechanisms for this negative relationship between stock liquidity and corporate innovation by using the takeover exposure model of Cremers, Nair, and John (2009). Fang (2013) found out that an increased hostile takeover threat and holdings of non-dedicated institutional investors might put more pressure on managers to increase current earnings. Hence, managers can reduce the firm's chance of being taken over and reduce long-term investments, which could add value to the firm's sustainability. In summary, these two mechanisms are mainly the reasons that lead to the failure of innovation.
5. Tolerance for Failure and Firm Innovation 
Innovation is vital for building up a competitive advantage for the company in the long run. As Holmstrom (1989) indicates, innovation activities encounter a high chance of failure, and the process involves many future alternatives that we are unable to forecast. Thus, innovation activities need exceptional tolerance for failure. Manso (2011) points out that motivate exploration requires the tolerance for failure in the short run and can lead to the reward for success in the long run.
To test out the relationship between tolerance for failure and firm innovation, Tian and Wang (2011) use a novel empirical approach to study VC investor's attitudes towards failure and examine how their attitudes impact the innovation in their invested firms. The reason for choosing VC-backed firms is based on the fact that VC firms involve high failure risk and high innovation potentials. Besides, Tian and Wang (2011) indicate that VC investors' attitude toward innovation plays a vital role in firm's success of producing innovative activities because VCs can decide to continue or stop investments in the projects when they underperformed.
Therefore, researchers link VC investor's failure tolerance to IPO firms backed by VC investors based on the fact that "failure tolerance measure captures the investing VC investor's attitude towards failure before the first investment in the startup firm (Tian and Wang, 2011)". They found out IPO firms backed by more failure-tolerant VCs are more innovative based on the high quality and quantity of innovative outputs (patents) they produce. However, to further examine whether is some ex-ante project or VC characteristics rather than their failure tolerance affect the result, Tian and Wang use three different identification strategies to conduct the analysis。
In the first strategy, Tian and Wang (2011) use the average investment duration in a VC's past successful projects as an alternative "failure tolerance" measure and found out there is no unobservable ex-ante character in affecting the result. The second identification strategy is to take control of characteristics to see how they each affect the VC firm's investment preference. It turns out that "the effect of VC failure tolerance on startup firm innovation cannot be explained away by controlling for the lead VC firm fixed effects." Tian and Wang (2011) use the third identification method to find out that VC's failure tolerance to entrepreneur innovation is reflected by the marginal impact of the measure on innovation if the failure tolerance measure reveals a VC investor's attitude towards failure.
In conclusion, Tian and Wang (2011) found out that when the risk of failure is higher, the impact of VC's failure tolerance on startup innovation is much more substantial. Also, the researchers point out that ventures that born in recessions, at early stages, or in the industry that innovation is difficult to reach needs failure-tolerant VC to finance. Moreover, they mention that younger and less experienced VCs are less failure tolerant than older and more established VCs (Tian and Wang, 2011).
6. Conclusion
It is crucial for companies to maintain their competitive advantage. One of the most important ways to improve their competitive advantages is to add long-term value to its core competence and expertise by developing and motivating its firm innovation. This paper emphasizes on how companies could promote or nurture innovation from different perspectives by reviewing and summarizing key findings that focused on how financing activities can influence firm innovation. On the one hand, we found out that better utilization and empowerment of CVC and hedge fund activism could give entrepreneur companies more synergy and enhance their innovative output. On the other hand, researchers emphasize that lower coverage of financial analyst and stock liquidity would help managers reduce their pressure to chase the short-run earnings by cutting down innovative long-term investments. Furthermore, consistent with the previous findings, if investors have more patience and tolerance towards startup failure, firm innovation will be more likely to be nurtured in the future stage. It is still a long way for us to step on and more secrets that need us to discover to motivate innovation. Still, with the knowledge and findings we have, I believe that we will embrace a better future and lead businesses to innovate.

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