Internal sources for financing innovation

Internal sources of finance are critical for firms’ innovation activities. This includes notably retained earnings, the profits accumulated over time which have not been returned to shareholders. Firms often use internal financing rather than external financing.
Several factors shape firms’ decisions to allocate their own resources to financing innovation:
  • Sources as diverse as money and capital provided by family and friends to start a business as well as entrepreneurs’ personal financial resources can be important resources for innovative entrepreneurs (see Private sources of funding). Private sources of funding are often essential for start-ups since information asymmetries often render access to finance on markets difficult. They can help entrepreneurs obtain debt financing, along with funding from venture capital and business angels. Public policy can play a role by establishing bankruptcy regulations so that innovative entrepreneurs will be more willing to invest in innovative businesses.
  • Large firms with multiple divisions can fund their innovation investments in one division, even if a new one, with retained earnings from other divisions. In this case, corporate headquarters allocate scarce funding across different divisions in an internal capital market, using a variety of mechanisms to select what competing projects to fund. The importance given to innovation activities will be particularly critical in this context (see Resource allocation mechanisms within firms). 
  • The separation of ownership and control can also lead firms to display short-terminist behaviour. This is a concern in particular for companies that are listed in the stock market and have a diversified shareholder base. For a variety of reasons stock market prices may fail to accurately reflect firms’ investments in innovation (among others) and the returns that they are expected to generate in the long term. As a result, myopic behaviour by financial intermediaries can sometimes punish management teams that heavily invest in innovation activities, since investors observe lower profits today but fail to appreciate the higher long-term profitability that is expected. There is an on-going debate on whether private equity is a good alternative to focus managers’ attention on long-term profitability. While it might insulate managers from having to satisfy market expectations, it might lead to prioritize medium-term profitability (see Long-term and short-term profit objectives).  
  • Moreover, the competitive environment can impact how many internal resources are available for innovation. Firms can recoup the fixed cost of investing in innovation by selling the resulting product at a price that is higher than the marginal cost of producing it. Firms use a variety of strategies to sustain this mark-up, such as using intellectual property (e.g., patent the invention), first-mover advantage (e.g., build a large consumer base) or secrecy. However, these strategies are not always successful in practice, so if markets are very competitive it can be difficult to sustain a mark-up to cover the costs of the innovation process. This is why there is some research suggesting that there is an inverse-U-shaped relationship between competition and innovation. Without competition there is very little pressure to innovate, but with too much competition investors may be reluctant to fund innovative activity if they fear that even if successful it will be difficult to capture the benefits of this success (see Competitive environment and resources for innovation).
Finally, while having access to internal resources facilitates investment in innovation by avoiding many of the challenges that arise for firms as they seek external sources of finance, it also makes it easier to undertake potentially unproductive investments. Not being required to convince external providers of finance gives managers the freedom to use their firms’ retained earning with high discretionality. This can be good if it leads to profitable investment that would not happen otherwise, but bad if CEOs spend these funds on activities that are beneficial to them rather than to maximize long-term shareholder value.
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