Firm strategies and performance >

Overview and description of publications

• Overview of the research program
• An overview of the importance of entrants
• A profile of entrants
• Innovation and entrants
• New-firm survival
• Innovation and performance in small and medium-sized firms
• Characteristics of bankrupt firms
• Innovation archetypes
• The role of industry environment
• Innovation type and its relationship to an industry's science base
• Financing investments in knowledge

Overview of the research program

This set of projects on firm strategy is an outgrowth of an earlier study, The Dynamics of Industrial Competition: A North American Perspective (Cambridge: Cambridge University Press), which investigated the dynamics of change in the industrial sector-entry, exit, mergers, the extent to which incumbents were replacing one another as some gained and others lost market share, and the impact of these changes on performance-using longitudinal data bases that track firms through time.

While the Dynamics book has produced new evidence on the amount of change taking place in the industrial world, it only touched the surface as to what causes these changes. It provided counts of entry and exit, measured their importance using market share, and tracked their progress in terms of size and productivity. But it provided little information on the nature of the individual firms.

To build richer data sets on industrial units that are in transition, new surveys were developed that allow us to better understand the internal workings of the firm. These surveys bridge the divide that exists between the disciplines of economics and management science. Traditionally, the field of economics has rarely tried to go beyond a characterization of a firm as an aggregation of labour and capital. The management literature, however, has long wrestled with describing a firm in richer detail-as a bundle of internal competencies. This research builds on this tradition and develops a set of surveys that have allowed us to develop a snapshot of the strategies, competencies and activities of different firms.

This research draws on an array of new survey and administrative data sources. It uses survey evidence derived from random samples of entire populations in order to draw a comprehensive and reliable picture of the small-firm population, or of specially designated sub-samples of the small-firm population. It also draws on sets of questions covering a range of innovation related activities that enable us not only to examine the R&D activity of small firms, but also other aspects of the innovative process-whether new technology is being acquired, whether production engineering is important, the extent to which the patent system is being utilized and whether skilled labour is being used to enhance the human capital base of the firm. The surveys are linked to administrative records on sales, productivity, and profitability data to examine the connection between the strategic emphasis of a firm and its performance.

Five specially-designed surveys that were conducted by Statistics Canada are used in this project. Each of these surveys explores different aspects of innovation and performance in the small-firm sector. The surveys include:

• Survey of Growth (1992)
• Survey of Innovation and Advanced Technology (1993)
• Survey on the Characteristics of Bankrupt Firms (1995)
• Survey of Operating and Financing Practices (1996)
• Survey of Innovation (1996)

All five surveys were developed after substantial pre-production testing and evaluation of the underlying target populations. Each was based on a random sample drawn from Statistics Canada's Business Register-a comprehensive list of all firms with employees in Canada. Four of the five surveys had very high response rates, ranging from 70% to 90%.

Two of these surveys-Survey of Growth Companies and Survey of Operating and Financing Practices-were also linked to administrative data sources at Statistics Canada in order to obtain quantitative measures of performance (notably sales growth, productivity and profitability). One administrative data source-the Longitudinal Employment Analysis Program-was also used to study patterns of new-firm survival.

The surveys contain questions that allowed for comparison of differences in the emphasis that firms give to strategies and activities in different functional areas-management, human resources, technological, finance, marketing, etc..

Strategies encompass the overall organizational plan that is adopted to meet the firm's goals. In the area of strategies, the surveys explore the priorities of firms in the functional areas of management, marketing, financing, and human-resource development, as well as more specific questions on innovation, training, financial structure, and the use of government programs.

The surveys also provide data on measurable activities of firms. Activities are the tasks that are required to implement strategies. They involve financing, hiring and training personnel, purchasing technology and capital equipment, establishing research and development facilities, co-ordinating and monitoring personnel. Activities in these areas reflect previous strategy choices, provide evidence on the degree of expertise available in firms, and suggest the potential for future success. To this end, the export orientation, the capital structure, the sources of financing, the employment composition by occupational category, the investment intensity in R&D and marketing, the sources of innovation, and the training policy of each firm are all investigated.

This information on different strategies and activities of firms provides an integrated profile of a broad range of the type of diverse activities that must be mastered by a firm—management skills, marketing abilities, human-resource development, financing capabilities, and innovation expertise. It permits an evaluation of the areas that are critical to success, how the winning combination of policies varies as the industry environment changes, and whether firms in different industries pursue similar strategies and objectives.

Taken together, these survey and administrative data sources allow us to profile a broad cross-section of small firms-businesses that have survived into adolescence, businesses that are growing, businesses that are innovative, and businesses that have failed.

The survey results were merged with the longitudinal databases in order to analyze the strategic differences between firms based on their performance over time. The research then examined whether a group of firms that were more successful, based on a performance metric of growth or profitability or innovation, possesses a different set of competencies than those who were less successful.

An overview of the work on innovation strategies in small firms is provided in the book:

Baldwin, J.R. and G. Gellatly. 2003. Innovation Strategies in Small Firms. Cheltenham, UK: Edward Elgar.

Top of Page

An overview of the importance of entrants

Before the strategic emphasis of small-firms is examined, their role needs to be set in context. In order to do, the first study examines the importance of small firms, in particular entrants.

Each year entrants comprise a significant share of the industry landscape. Between 1984 and 1986, new firms in any one year accounted for 19% of total businesses. Over time, the impact of new firms on an industry's structure is dramatic. Seventy-four percent of all firms in operation in 1995 came into existence after 1984.

The net effect of entry, however, is tempered by the fact that many new businesses fail, often very quickly after entering the marketplace. Only one in five entrants reach their teen years. Industries are in a constant state of turbulence—one shaped by the continual emergence, growth and decline of new firms.

Small firms play an especially important role in the dynamics of entry and exit. Firm turnover has a substantial impact on aggregate productivity. Between 20 to 25% of productivity growth in Canadian manufacturing during the 1970s came from entrants and exits. Much of this growth, particularly in the small-firm sector, originated from a process of displacement wherein small new firms replace low-productivity incumbents who exit.

Baldwin, J.R. 1999. A Portrait of Entrants and Exits. Analytical Studies Research Paper Series 11F0019MIE1999121. Analytical Studies Branch. Ottawa: Statistics Canada.

Baldwin, J.R., D. Beckstead and A. Girard. 2002. The Importance of Entry to Canadian Manufacturing with an Appendix on Measurement Issues. Analytical Studies Research Paper Series 11F0019MIE2002189. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

A profile of entrants

The next study provides an overview of entrants and their strategies. It starts by examining the environment faced by entrants. Focusing first on whether entrants are to be found primarily in new or in mature markets, it then delineates the type of competitive environment that entrants face. The second part of the study develops a profile of the competencies of entrants, noting that most new firms stress the importance of management, human resources, and marketing. This is because small firms rely heavily on producing products that are of high quality with a flexible production system that can meet changing consumer demand. For this, flexible management is important. So too is a marketing strategy that keeps existing customers.

These studies also explore strategic factors associated with survival and growth. Among long-run entry survivors, performance differentials emerge. A critical finding is that growing new businesses are much more likely than other firms to bring new products and processes to market. They are more innovative.

Innovation strategies that support growth are often tailored to the dynamics of the marketplace. In industries where product markets are in an early growth phase, product characteristics evolve rapidly; these are markets in which high-growth small firms capitalize on product development strategies. In more mature markets, production strategies come to the fore, serving to distinguish more successful entrants from other small firms. Innovative small firms also report a more intense mix of competitive pressures-more rapid technological change and product obsolescence—than do other businesses.

Johnson J., J.R. Baldwin and C. Hinchley. 1997. Successful Entrants: Creating the Capacity for Survival and Growth. Catalogue No. 61-524-XPE. Analytical Studies Branch. Ottawa: Statistics Canada.

Innovation and entrants

Because entrants are often seen as one of the key methods by which new products and processes are introduced to the industrial system, this research study analyzes the amount and type of innovation that is found in the entrant population.

The results indicate that surviving entrants develop a wide array of innovation competencies, all of which speak to the propensity for knowledge creation in small firms. New products and processes, advanced technology use and investments in human capital all contribute to the commercialization of new ideas. Each represents a different strategic emphasis, which serves to illustrate that there is no single path to innovation. Successful new firms often combine these innovation inputs with product, market and production strategies that emphasize specialization, quality and flexibility—key elements of competition in the small-firm sector.

Baldwin, J.R. 1999. A Portrait of Entrants and Exits. Analytical Studies Research Paper Series 11F0019MIE1999121. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

New-firm survival

The strategic profile of successful entrants developed in the two previous studies is based on the elite 20% of new firms that reach their second decade of life. For most new businesses, however, life is short and uncertain. One half of all entrants fail before reaching their third anniversary.

Therefore, this study investigates the determinants of failure-by asking whether high post-entry hazard rates are driven by the idiosyncrasies of individual firms, the competitive dynamics that shape industries, or the larger macroeconomic climate. While all these affect the probability of survival, changes in firm-specific factors—idiosyncratic characteristics that proxy changes in relative efficiency—have the largest quantitative impact on the hazard rate. New firms that are larger than their "average competitor" (other first-year firms in the same industry) are in a much better position to survive than are entrants with size disadvantages. Size is related to a firm's functional competencies—whether in terms of management, marketing, financing or production. Firms that make greater investments in the development of these competencies are in a better position to compete. Learning-by-doing also plays a role in shaping post-entry performance, as firms become less vulnerable to failure as they acquire market experience. Industry dynamics have less impact on the hazard or failure rate than either an entrant's size or age characteristics. This said, more competitive industries are more likely to cull new firms.

The results indicate that the investments that new small firms make in their productive capacity at an early stage in life have a major bearing on post-entry performance. As new firms expand their productive capacity, they also expand their set of core competencies. This is not to suggest that new small firms seek to obtain scale economies of the sort enjoyed by large incumbents. Rather, by investing in their productive capacity, new small firms improve their competitive position relative to their main rivals, other small firms. By the time entrants emerge into adolescence, many have acquired a broad set of functional competencies that support the development of innovations. Those who do not do so fail to grow and have much higher exit rates.

Baldwin, J.R., L. Bian, R. Dupuy and G. Gellatly. 2000. Failure Rates for New Canadian Firms: New Perspectives on Entry and Exit. Catalogue No. 61-526-XIE. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

Innovation and performance in small and medium-sized firms

These research studies investigate the relationship between innovation and performance by analyzing the strategic stance and activities of growing small and medium-sized entrants. These are firms that grew their asset and employment bases over the 1984-88 period. The studies examine the emphasis that small and medium-sized firms give to developing competencies in a wide range of areas—from management to human resources, marketing, finance, technology acquisition and research and development. In this area, we also ask which strategies and competencies are more closely associated with success, by comparing high-performance and low-performance firms within this sample.

Success, of course, has many different dimensions-such as growth, profitability and productivity. In this study, we develop a composite index of success based on changes in market share (which captures a firm's growth performance relative to its competitors), changes in labour productivity, and a profit-to-sales ratio.

The overall profile that is developed of small and medium-sized firms in this study is not dissimilar to that outlined in the strategic profile that was developed of new firms. These are firms that compete against large firms with a product offering that stresses quality and flexibility. In small firms, the key managers are very important. Human resources receive the second highest stress. Technology and research and development fall at the bottom of the list of key competencies that managers of these firms stress.

Nevertheless, the results of this study are noteworthy in that they show that firms that place more stress on innovation are more likely to succeed. The development of innovation competencies—as evidenced by the presence of a research and development unit, and high levels of expenditure on research relative to sales and investment—all serve to distinguish more- from less-successful businesses, regardless of industry membership. High-performance firms attach more importance to a wide range of strategic objectives designed to complement investments in innovation, such as (1) accessing new markets; (2) obtaining new technology (either by developing technology or acquiring and refining existing technology); and (3) improving the efficiency of production. Other more basic business competencies—management, worker skills, product quality and flexibility—are less powerful predictors of high-performance.

These findings underscore the relationship between core business competencies and specialized innovation capabilities: all growing small and medium-sized enterprises share a commitment to developing core business competencies (many of which are absent or underdeveloped in declining firms); it is specialized competencies in areas that support innovation (e.g., research and development and technology utilization) that differentiate firms in the marketplace, separating the leaders from the pack.

Baldwin, J.R., W. Chandler, C. Le and T. Papailiadis. 1994. Strategies for Success: A Profile of Growing Small and Medium-sized Enterprises in Canada. Catalogue No. 61-523-RPE. Analytical Studies Branch. Ottawa: Statistics Canada.

Baldwin, J.R., M. Rafiquzzaman and W. Chandler. 1994. "A Profile of Growing Small Firms." Canadian Economic Observer. Catalogue 11-010-XPB. February. Ottawa: Statistics Canada.

Baldwin, J.R. 1995. Innovation: The Key to Success in Small Firms. Analytical Studies Research Paper Series 11F0019MIE1995076. Analytical Studies Branch. Ottawa: Statistics Canada.

Baldwin, J.R. 1996. "Innovation and Success in Canada: Small and Medium-Sized Enterprises". In J. de la Mothe and G. Pacquet (eds.) Evolutionary Economics the New International Political Economy London: Pinter.

Top of Page

Characteristics of bankrupt firms

As important as successful new entrants or growing small and medium sized enterprises are, many firms fail. Understanding what is happening to this portion of the population is important if an overview of the entire population of small firms is to be developed.

Therefore, this study examines in more detail which firm-level competencies (or the absence thereof) are most associated with business failure. The study finds that it is not the absence of sophisticated business strategies that leads many young firms to fail, but rather skill deficiencies in core areas, specifically those related to management and financing. Over 70% of bankrupts cited problems with general management and financial management as major factors contributing to their bankruptcy. The most significant limitations in the area of general management include lack of knowledge, lack of vision and the poor use of outside advisors. Common financial problems include undercapitalization and an inability to manage working capital. One-third of all bankrupt firms were also hampered by a lack of resources that would have enabled them to pursue external financing options. This dependence on internal sources of capital was particularly problematic among small firms. But it also was related to deficiencies in the area of financial management.

The results of this study underscore the importance of developing a core set of business skills. If new small firms are to reach adolescence, they have to emerge into their teen years with a broad array of competencies in core functional areas, such as financing, human resources or marketing. In addition, the results of other studies indicate that if they are to grow faster than average, they also need to develop competencies in specialized areas like research and development and technology that support innovation strategies.

Nevertheless, the key finding of the study of bankrupts is that young small firms that exit the marketplace often lack basic business skills in key functional areas. Many of these limitations, in turn, preclude the development of successful innovation strategies. Firms that lack sound financial and managerial foundations are not in a strong position to develop and exploit new knowledge.

Baldwin, J.R., T, Gray, J. Johnson, J. Proctor, M. Rafiquzzaman, and D. Sabourin. 1997. Failing Concerns: Business Bankruptcy in Canada. Catalogue 61-525-XIE. Analytical Studies Branch. Ottawa: Statistics Canada.

While most bankrupts are very young, there are others who have reached a degree of maturity before they fail. The following study examines the factors underlying firm failure and contrasts the failure mechanism for younger and older organizations. It finds systematic differences in the determinants of failure of those who fail early in life and those who fail after having successfully negotiated the early liabilities of newness and obsolescence. Firms that have inadequate managerial knowledge and financial management abilities are more likely to fail at a young age. Older firms, on the other hand, are more likely to fail because of an inability to adapt to environmental change brought on by market turbulence caused by a change in market conditions, the obsolescence of technology, or legislative change.

Thornhill, S. and R. Amit. 2003. Learning from Failure: Organizational Mortality and the Resource-based View. Analytical Studies Research Paper Series 11F0019MIE2003202. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

Innovation archetypes

While innovation is closely related to success, innovation itself is a complex and varied activity. Innovation strategies can take many different forms. This study explores the dominant innovation archetypes within growing small and medium-sized enterprises, and examines how strategic differences within these archetypes are correlated with various aspects of success. To do so, innovative firms are separated into three broad groupings: product innovators, process innovators and comprehensive innovators (firms who stress both product and process innovation).

Product innovators are firms that place a high value on continually developing and offering new products, with little emphasis on improving their technological capability and production efficiency. Process innovators are at the other extreme-they devote substantial resources to technology adoption and improving their production processes, and less effort to product development. The final group, comprehensive innovators, are businesses that pursue a broad mix of innovative activities. These are firms that emphasize both process technology and product development by drawing on a wide range of sources for innovative ideas (e.g., marketing, management, research and development and patents).

Each innovative group was then divided into more- and less-successful firms based on a performance index that combines information on productivity, profitability and market share. This, in turn, reveals which factors are associated with performance differentials within groups of firms that share common innovation strategies. The differences demonstrate that, within each group (product, process and comprehensive innovators), the more-successful firms are those that give greater stress to innovation strategies and competencies, that stress the development of skilled personnel, and that export a large percentage of their sales.

Other strategic differences emerge between more- and less-successful firms within each innovator group. High-performance product innovators are those that devote more attention to process innovation and human resources strategies. These firms make less use of debt and stress innovative financing. High-performance comprehensive innovators (firms that adopt strategies with a broad mixture of product and process characteristics) pursue more radical types of innovation based on research and development capabilities. But these high-performance firms also place more emphasis on a wide range of functional areas—management, marketing, human resources and financing. Finally, high-performance process innovators are those that place a greater emphasis on longer term financing, especially from banks.

Comparisons between the three innovator groups show that firms with comprehensive strategies tend to be the most successful, outperforming firms that only have product or only have process innovations in terms of their growth in market share and profitability. Comprehensive innovators are also more compleat firms-in the sense that innovation strategies within these firms receive greater support from a broader array of strategic competencies in other areas. Marketing, financing and management strategies are well developed within these firms, and contribute to their success.

Baldwin, J.R. and J. Johnson. 1995. Business Strategies in Innovative and Non-Innovative Firms in Canada. Analytical Studies Research Paper Series 11F0019MIE1995073. Analytical Studies Branch. Ottawa: Statistics Canada. Also published in Research Policy. 1996. 785-804.

Baldwin, J.R. and J. Johnson. 1996. "Human Capital Development and Innovation: A Sectoral Analysis". In The Implications of Knowledge-Based Growth for Micro-Economic Policies. Peter Howitt (ed.). Calgary: University of Calgary Press.

Baldwin, J.R. and J. Johnson. 1997. Differences in Strategies and Performances of Different Types of Innovators. Analytical Studies Research Paper Series 11F0019MIE1997102. Analytical Studies Branch. Ottawa: Statistics Canada.

Baldwin, J.R. and J. Johnson. 1998. "Innovator Typologies, Related Competencies and Performance". In Microfoundations of Economic Growth edited by G. Eliasson and C. Green. Ann Arbor: University of Michigan. 227-53.

In addition to the above pieces, a research study also explores the difference between innovators and non-innovators in a particular sector—business services. Innovators are found to attach greater importance to financial management and capital acquisition. Innovators also place more emphasis on recruiting skilled labor and on promoting incentive compensation schemes. These distinctions emphasize that in R&D-intensive industries, financing and human-resource competencies play a critical role in the innovation process.

Gellatly, G. 2000. Differences in Innovator and Non-Innovator Profiles: Small Establishments in Business Services. Analytical Studies Research Paper Series 11F0019MIE2000143. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

The role of industry environment

Innovation strategies often reflect the dynamics of the industry environment. This study uses one aspect of this environment, the industry lifecycle, to explore differences in innovation patterns.

Firms that stress product innovation tend to emerge during the early growth-stage of an industry, when product lines are rapidly evolving. Process innovators often come to the fore in more mature markets when product lines have stabilized. In the study on small and medium-sized firms, we outlined other differences in the relationship between innovation and success that are found in goods as opposed to service industries. In manufacturing, it is R&D that drives success. In many of the service sectors, it is an innovation policy organized around human capital or skilled workers. In primary industries, it is an innovation policy organized around the acquisition and application of new technologies.

This study on small firm strategies extends our exploration of differences in the industry environment-by focusing on how elements of innovation relate to various characteristics of the marketplace that help to determine the intensity of competition in an industry (e.g., the threat of entry; whether customers can readily defect to new producers, …). Our analysis here examines innovative businesses that operate in three major industries-communications, financial services and business services. All are examples of dynamic service industries that share, in varying degrees, an emphasis on advanced technology, an international orientation, and a critical role in supporting the production and distribution activities of other sectors. Two of these industries, communications and business services, are dominated by small firms. Businesses with less than 100 employees comprise 89% and 95% of the populations in these industries.

The results show that innovation strategies in each of these service industries share a set of common characteristics, many of which are typically associated with small firms. Improving product quality, flexibility and catering to diverse tastes are important aspects of innovation in all three sectors. Customers are the most important source of new ideas.

Beyond these characteristics, however, innovation strategies take different forms, in ways that are consistent with, if not direct responses to, differences in key features of the competitive environment of the communications, finance and business service sectors.

Communications firms operate in a marketplace where production technologies evolve rapidly and capital assets have low liquidation values. Innovative firms here rely extensively on the use of advanced technologies and technology acquisition, often by developing networks with suppliers and outside firms. Relatively little emphasis is placed on the development of in-house research and development capabilities. Regulation is regarded as a relatively important impediment to innovation.

Competition in the financial services industry is driven by a different set of competitive pressures. Price, flexibility, and customer service are key factors. Financial services firms often look to their competitors for innovative ideas. Innovation strategies are designed to yield new products that satisfy a diversity of customer wants and are price competitive. Firms place a heavy emphasis on human resource strategies in order to improve labour productivity and service quality (e.g., worker incentives, acquiring skilled labour and training). Innovations are also designed to reduce unit costs, an important objective in a price-competitive marketplace.

Firms in the business services industry face a relatively wide array of competitive pressures compared to those in communications and financial services. Product obsolescence, difficulty in predicting competitor behavior, and changes in consumer demand are all more significant forms of uncertainty here than elsewhere. In response to a more diverse mix of competitive pressures, business-services firms adopt a more diverse and varied mix of innovation strategies. They draw on more sources for innovation ideas, highlighting a broader range of objectives, and their innovations have a wider range of impacts—from improving quality, to reducing costs, to increasing reliability. Innovation strategies are outward looking, driven by the need to expand the customer base into foreign markets. Product standards in this industry change rapidly. Accordingly, firms make substantial investments in developing their research capabilities, and use a more diversified mix of intellectual property rights.

Baldwin, J.R., G. Gellatly, J. Johnson and V. Peters. 1998. Innovation in Dynamic Service Industries. Catalogue 88-516-XIE. Analytical Studies Branch. Ottawa: Statistics Canada.

Gellatly, G. and V. Peters. 2000. Understanding the Innovation Process: Innovation in Dynamic Service Industries. Analytical Studies Research Paper 11F0019MIE2000127. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

Innovation type and its relationship to an industry's science base

This study extends our examination of the effect of industry environment by focusing on new firms in two broad groupings of goods and services industries-those with a strong science base and those for which investments in scientific knowledge play less of a role.

New firms in the science-based sector and those in other industries face certain common market pressures (e.g., in terms of the average numbers of competitors and the degree of competition from startups). However, long-run survivors in science-based industries face more volatile shifts in consumer demand and they are dependent on a smaller number of customers. In turn, differences in substitutability are associated with differences in competitive strategies. New firms outside the science-based sector give a greater emphasis to price competition since it has such an immediate effect on the tendency of customers to switch from one supplier to another. On the other hand, new firms in the science-based sector focus more on the frequency of new product introduction, and or product customization in order to minimize customer loss.

This difference in the environment is manifested in large and significant differences between the two groups in their innovation system. New firms in science-based industries are more likely to innovate. They are particularly more likely to introduce product innovations. Rapid technological change is a defining feature of science-based environments. Differences in the rate of product innovation are reflected in differences in the emphasis that is given to R&D and to the emphasis given to new technology. Entrants in science-based industries make more use of the patent system. Successful entrants in science-based industries also pursue more aggressive marketing strategies to reach their customers. They target both new domestic and new foreign markets more than do firms in the other sector. To alleviate their dependence on a small customer base, firms in science-based industries turn more to export strategies. These firms also place more emphasis on inter-firm networks that bring together customers and suppliers.

Associated research studies demonstrated that small- and medium-sized innovative firms placed greater stress on developing their competencies in a wide range of areas, relative to other non-innovative firms. The findings of this research study indicate this result is true for new firms as well. New firms in science-based industries differ from their counterparts in other industries across a large number of dimensions. New firms in science-based industries place greater emphasis on enhancing their competencies in the areas of technology, human resources, production, and marketing. Differences in human resources are particularly striking. Innovation and R&D—common in the science-based industries—require superior skills to acquire new technologies, retrain a firm's workforce in order to produce new products, and to market new products.

The financial structure of new firms also differs substantially between the two groups. Equity capital—in the form of either retained earnings or share capital—is more important in the science-based sector. Conversely, long-term secured loans account for a larger proportion of total capital in other industries. Not surprisingly, then, retained earnings and funding from owner managers are more important in the science-based sector, whereas banks are more important in other industries.

Firms in the science-based sectors face different conditions attached to their financing, which suggests these firms are more difficult to monitor. The conditions attached to financing are more likely to be related to operating conditions than to simple financial operating ratios. This indicates that the latter are more difficult to interpret in the science-based sectors, since so much capital is in the form of knowledge and investments in knowledge are more difficult to evaluate.

The existence of financing difficulties in the science-based sector accords with the greater reliance of new firms on internal sources of financing for knowledge-based assets. Science-based firms are not only more likely to require financing for soft assets, but they are more likely to raise funds for these purposes from retained earnings. This means that there is a close connection between success and profitability in science-based industries. Internal sources of funds are more critical to the key expenditures on research and development, technology acquisition, and training that lead to growth in science-based industries than elsewhere.

It is also the case that hard assets like machinery and buildings in science-based industries that provide ready collateral are more likely to be financed out of retained earnings and less likely to be financed out of loans. The differences in the frequency of loans for hard assets in firms in science-based industries provide more evidence of potential financing problems in science-based industries. Firms in science-based industries are less likely to use long-term secured loans for R&D, technology acquisition, market development, and training—but they are also less likely to use these sources for machinery and equipment purchases. Thus, new firms in science-based industries not only have to rely more on internal funds because they have a greater percentage of their investments in the types of expenditures that provide softer collateral that is harder to evaluate; but they also apparently are considered by lenders to have particular difficulties even in areas where there should be more 'hard' collateral—perhaps because the overall risk experienced by firms in these industries is higher than elsewhere.

Baldwin, J.R. and J. Johnson. 1999. The Defining Characteristics of Entrants in Science-based Industries. Catalogue No. 88-517-XIE. Analytical Studies Branch. Ottawa: Statistics Canada.

Top of Page

Financing investments in knowledge

This research study investigates the financial structure of small firms. It uses data derived both from the GSME survey and the survey of entrants. Its first purpose is to provide a picture of the financial structure of small firms. It finds that small firms rely much more on equity than do large firms. Moreover, small firms are more likely to use fewer types of the different sources of funds available.

Its second purpose is to ask how the financial structure of smaller firms varies across different risk categories. To do so, it examines the relationship between financing and knowledge creation, by focusing on successful entrants—new small firms that have survived their first decade of operation. These are firms that have had time "to grow and adapt" their financial structures, that is, to select an optimal combination of financial instruments and sources that, subject to preferences and costs, allow the firm to best pursue its business objectives.

Issues of small-firm financing garner considerable discussion. Small firms are often said to suffer from "deficient" financial structures in that they do not have access to the range of financing options that are readily available to large firms. New small firms in high-technology industries allegedly face credit rationing in traditional debt markets, which in turn has fueled the growth of specialized financial intermediaries.

This study investigates how the financial structure of successful entrants varies with basic differences in knowledge intensity. Investments in knowledge are measured in two ways-first, by focusing on differences in the knowledge base across individual industries, and second, by examining investments in knowledge creation at the level of the firm. Innovation—the successful commercialization of new knowledge—is inherently risky. Successful new products and technologies may yield high payoffs for owners, workers and investors; unsuccessful innovations, particularly if they require substantial outlays in inputs like research and development, may entail equally high losses. This study asks whether variations in financial structure are strongly correlated with underlying differences in the firm's exposure to risk.

The results show that firms that are more innovative tend to rely more on equity, particularly retained earnings, than less innovative firms. The differences are particularly marked across industries. That is, firms in high-knowledge industries differ from those in low knowledge industries considerably more than innovative and non-innovative firms differ within an industry. Firms also are more likely to use more equity in industries that are riskier. It is therefore industry characteristics that are linked most closely to differences in the extent to which firms rely on equity capital.

Nevertheless, the study finds that firms that conduct R&D are more likely to rely on equity in their capital structure. Equally important, there is evidence of a reverse causality from financial structure to innovative activity. Firms that rely more on debt than other firms are less likely to conduct R&D and less likely to be innovative.

Baldwin, J.R., G. Gellatly and V. Gaudreault. 2002. Financing Innovation in New Small Firms: New Evidence from Canada. Analytical Studies Research Paper Series 11F0019MIE2002190. Analytical Studies Branch. Ottawa: Statistics Canada.

Gellatly, G., A. Riding and S. Thornhill. 2003. Growth History, Knowledge Intensity and Capital Structure in Small Firms. Economic Analysis Research Paper Series 11F0027MIE2003006. Analytical Studies Branch. Ottawa: Statistics Canada.