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The Daily

The Daily. Friday, May 24, 2002

Financing innovation in successful small firms

Certain financial strategies are more advantageous than others for small firms when it comes to supporting their investments in research and development and innovation, according to a new study that profiles the use that small business makes of different financial instruments.

The study showed that small firms that use more long-term debt channel fewer of their investment resources into research and development, which are investments strongly related to growth and innovation. More debt-intensive financial structures act to constrain such investments.

The businesses this study profiles are "successful entrants", the elite 20% of new businesses that have survived their first decade of life. These firms come from many different sectors of the economy, representing a broad range of goods and service industries.

For the small firms examined in this study, the impact of increasing debt financing on the innovation process works by reducing research and development. When the study took into account differences in the research and development profiles of small firms, it found little evidence that different financial strategies affected the likelihood that a firm would introduce new products or services.

Small businesses face a more uncertain competitive environment than larger firms, evidenced by more variable rates of return and higher rates of failure. Firms that operate in riskier, innovative environments can be expected to face higher costs of external finance, which may lead many to rely more extensively on internal funds.

This study does not show that small firms are debt-constrained or equity-constrained. Small firms in high-knowledge industries may use more equity because debt is harder to obtain. Alternatively, they may use more equity because they prefer equity over debt.

But it does suggest that the type of financing has some bearing on the firm's tendency to invest in research and development. Firms that use more long-term debt channel fewer of their investment resources into research and development.

Data for this study came from the 1996 Survey of Operating and Financing Practices, which collected data on the business strategies and financial characteristics of successful small firms.

The study found that small firms rely heavily on equity financing. On average, nearly one half (47%) of small-firm financing comes from equity sources. More than 80% of this equity financing is retained earnings.

Traditional debt financing is the next major source of capital for small firms. On balance, 35% of the balance sheet is in the form of debt financing. More innovative sources of capital, such as venture capital, joint ventures and public equity markets, represent only small additions to the average balance sheet.

On average, small firms do not exhibit diversified financial structures. They rely on small numbers of instruments and sources of funding when financing their activities.

Differences in small-firm balance sheets are most apparent when comparing high-knowledge industries to low-knowledge industries. Small businesses in high-knowledge industries - those that place more emphasis on research and development and skilled workers - are far more equity-intensive than firms in low-knowledge industries. Debt financing plays a greater role outside the high-knowledge sector.

Financing innovation in new small firms: New evidence from Canada, no. 190, (11F0019MIE, free) is now available on Statistics Canada's Web site (). On our products and services page, choose research papers (free), then social conditions.

For more information, or to enquire about the concepts, methods or data quality of this release, contact John Baldwin (613-951-8588) or Guy Gellatly (613-951-3758), Micro-economic Analysis Division.



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Date Modified: 2002-05-24 Important Notices