THREE ESSAYS ON FINANCING INNOVATION DURING THE CRISIS

Abstract

The Global Financial Crisis of 2007-2009 has been widely considered as the worst re cession period since the Great Depression of the 1930s. Despite the roots of the crisis were entrenched in the U.S. housing bubble, clear signs only appeared when Bear Stearns liquidated two hedge funds that invested in various types of mortgage-backed securi ties. Following events, starting from the collapse of Lehman Brothers in September 2008, intensely shook the financial sector leading to banking panic, bankruptcy and public bail outs which rapidly spread globally to the real economy with harsh recessions, private defaults and high unemployment rates. In several European countries, the financial cri sis later developed into a proper Sovereign Debt crises which prolonged the recessionary environment and the global uncertainty. While during this period all companies faced a sharp drop in product demand and investments returns, innovative firms may have also particularly suffered from the credit crunch and financial turmoils which affected their ability to receive external financing on risky projects (OECD, 2012). Consequently, the turbulence brought about by the crisis may have modified or hindered the capacities and innovative path of companies, originating severe long-term consequences. So far, litera ture has only partially analyzed the consequences of the recent crisis on innovative firms. Noteworthy examples include Block and Sandner (2009); Filippetti and Archibugi (2011); Paunov (2012); Block et al. (2012); Archibugi et al. (2013). In particular, Archibugi and Filippetti (2013) gather a significant part of their latest empirical studies on the effects exerted by the recent downturn on the innovation activity of European firms. We con tribute to this stream of literature by investigating the impact of the crisis on financing innovation, taking a broad perspective. The analysis consists of three essays which separately explore the differential effects of economic downturns on heterogeneous samples of both young and newly founded Ameri can venture-backed start-ups and relatively mature and established Italian firms. We aim to shed more light on the effect of the crisis on funding availability, venture project selec tion and innovative performances. The first two essays focus on U.S. start-ups financed by venture capitalists. The third essay examines a larger sample of Italian established businesses, shedding light on their innovative activity and financial profile. However, the choice of the topics is not accidental. On the one hand, U.S. represents the most rele vant example of countries where the Global Financial crisis hit harshly, but eventually resulted in a temporary negative shock followed by a relatively fast recovery. Moreover, it is characterized by the high availability of specialized financial intermediary which invests money raised from institutional investors or wealthy individuals, in promising start-ups characterized by prevalence of intangible assets, years of negative earnings, facing high risk, but potentially with high-rewards. However, a sudden and enduring decreasing of venture capital finance, due to a financial shock, may have jeopardized a pivotal source of funding in key sectors for growth and economic development. On the other hand, Italy is an interesting alternative scenario. First, it was exposed to a longer double-dip recession with a following sluggish recovery that has not reached yet the pre-crisis levels. In fact, the Italian economy was severely hit first by the Global Financial crisis and later by the public debt crisis, which affected many other southern European countries. Second, un like U.S., equity markets are underdeveloped and the innovation funding relies mostly on internal resources or bank relationship (Accetturo et al., 2013). Moreover, even the pres ence of venture capital and other specialized equity investors is still lacking in comparison with U.S. and other European countries (Bronzini et al., 2015). The first chapter analyzes the effect of the Global Financial Crisis of 2007-2009 on U.S. venture capital market. Venture financing, by targeting enterprises and sectors where in formation asymmetries are stronger, typically young companies in high-tech industries, has been beneficial in bridging the funding gap for young and innovative firms (Hall and Lerner, 2009). Venture capital market has been historically highly cyclical and volatile as demonstrated by persisting fluctuations in number of investments and amount raised (Lerner, 2003; Metrick and Yasuda, 2010; Cumming and Johan, 2012). The Global Finan cial Crisis shook this industry, coming as an external shock, which obliged intermediaries to adapt and react to the changing environment. The chapter aims to revisit the existing empirical evidence (Block and Sandner, 2009; Block et al., 2012) by shedding new light on VCs’ behavior during a negative business cycle and measuring the effects in number of investments and funding size. By using a multiplicative interaction model which controls for development stage of the venture-backed company, firms’ characteristics, sector and regional effects, we test a differential effect during the crisis for each company stage. The empirical results of this study can be summarized as follows. First, descriptive analysis shows how the effect of financial crisis on venture funding depends on company stage at financing. In fact, when the conditional effect is measured, the reduction in number of deals and size of financing appears to be concentrated only on later stages, while VCs increased follow-on investments for seed and early stage companies. Second, there is a ceteris paribus effect of boosting the size of investments on early development stages, while reducing their exposure to later stages companies. Third, there is statistically significant evidence that, during the crisis, experienced venture capitalists reallocated their investments towards seed and early stage companies more than new and relatively inexpe rienced intermediaries. Forth, business angel and government sponsored programs have kept sustaining venture funding during the financial crisis, particularly in first rounds. Lastly, there is not enough evidence in support of any geographical change in VCs’ fund ing allocation during the crisis. Overall, we find clear evidence of a severe funding gap connected with the financial turmoil only for expansion and later stage companies. The study demonstrates that venture capitalists significantly changed investment strategies, boosting the size of investments on early development stages, while reducing their expo sure to later stages companies. These results reinforce the hypothesis of stage selective investing in order to postpone IPOs, avoiding the lower valuation during a crisis. The second chapter stems from the above mentioned findings to study the innovative outcomes of US venture-backed start-ups in the 2000s. We develop a novel longitudinal dataset which tracks down patenting behavior of 10,119 US venture-backed start-ups com panies and use cohort analysis on the financing cohorts 2001-2010. We examine whether the cohorts of companies selected and financed for the first time during financial crises are persistently less innovative than those financed over ordinary periods. The evidence confirms the existence of a generational effect in the companies selected during the Global Financial Crisis which display a persisting lower innovative potential. The empirical model identifies the alleged cohort effect on “recessionary startups”, disentangling it from cycli cal trends, the development stage, industry and region fixed effects, quantity of funds and other relevant factors. Results confirm a significant reduction of available funding coupled with a negative generational effect in the companies selected during the Global Financial Crisis which display a persisting lower innovative potential (about 30%), as measured by the number of issued patents over time. This evidence is robust to the inclusion of terms which take into account the age-related component, yearly fluctuations, together with other confounding factors. Additionally, the generational effect identified during the GFC is not evenly distributed across industries, but it concentrates in sectors like health care, industrial/energy and media and entertainment. We explained this finding with degree to which formalized innovation, as accounted by patents, is an entry requirement to compete in each market. In order to find confirmation of the view of cohort effect as the result of venture capital selection of safer but less innovative projects, the paper tests the correlation of this selection with lower probability to fail and also a lower valuation at exit. Evidence confirms the previous hypothesis. Similar effects are not identified during the previous market turmoil of 2002-2003, when venture capital markets were severely hit by the Dot-com bubble burst. This study highlights the differential consequences for innovation of external shocks which highly increase uncertainty (the Global Financial Cri sis) as opposed to traditional boom-and-bust phases (the Dot-com bubble) that reduce funding availability without changing innovative capabilities of financed start-ups. Lastly, the third chapter examines the innovative activity of a large sample of Italian non-financial companies during the double-dip recession. We aim to shed further light on the innovative performance of Italian firms between 2008-2012. By using a large dataset of 162,959 Italian non-financial enterprises, we analyze the financial characteristics of companies together with their patenting behavior. We compare the financial structure of innovative and non-innovative firms correlating it with the ability to achieve a sustained patenting over the years. One of the main contribution of this paper is represented by the overcoming of the classical dichotomy innovators vs. non-innovators, to adopt an enhanced categorization in four innovative classes (non-innovators, occasional, medium and great innovators), based on their degree of patenting between 2008-2012. Consequently, we will use the between-group differences measured on a large set of financial ratios to define each specific financial profile. The evidence shows that more than 80% of innovation is concentrated in the manufacturing sector. Among innovators, the majority engages in occasional innovation, while very few (mostly large) firms maintain a persistent level of high inventive capacity. Firms in the sample have slightly increased average patenting during the crisis with respect to the previous five years. The empirical analysis finds that Italian innovators are on average relatively large, mature and established. Their higher cash-flow and lower indebtedness clearly signal that they fund their activities mostly with internal resources. Moreover, they grow faster than non innovators, even during a recessionary period. The global picture that emerges is largely consistent with the hierarchical view of pecking-order theory. As we move from non-innovators to great innovators the use of cash flow to fund operations increases, while leverage decreases. However, the direction of causality is not addressed in this study. On the whole, Italian innovation shows both bright and dark sides. On the one hand, the majority of Italian innovators represent a coherent unit of good performers, endowed with a long-term vision, skills and means to pursue innovation and even to overcome adversities, such as the 2008-2012 recession. On the other hand, their number is extremely limited with respect to the Italian productive system. They are mainly concentrated in the manufacturing sector and definitely not sufficient to reverse the poor performance of the Italian economy in the last two decades. In order to start a significant catching up with the majority of European countries, a positive change both in extensive and intensive margin is required. Italy needs both the entry of new innovators and a significant increase in patenting performance among the persistent innovators. Overall, the conclusions of this work are in line with large part of the literature which highlights the differential impacts of the crisis across countries, industries and types of firm. However, a thorough understanding of the long-run effects of the crisis on heteroge neous innovative firms requires more time and reliable data. Therefore, this may represent a key topic for future micro level research.