Esade professor gives insights on how to optimise the financing of innovation

The way large firms finance research is crucial to their ability to invest in innovation, according to research co-authored by Esade Associate Professor Xavier Ferràs.

A study of data from 146 large European firms belonging to the Dutch Index AEX25, the French CAC, the German DAX, the British FTSE 100, the Italian FTSE MIB 40 and the Spanish IBEX 35, spanning ten years, investigated the relationship between internal and external financing and the amount of innovation carried out by the firms receiving the financing.

The study was conducted by a team of six researchers from Spain, Australia, Germany and Denmark.

The findings showed that in most sectors – basic materials, manufacturing and construction, services, financial and property services, and technology and telecommunications – firms focus on maintaining their core business, as long as it is profitable. Only firms in the energy sector increased innovation efforts when they increase profitability.

Profitability versus innovation

Successful innovation requires a significant financial commitment. However, when innovation leads to profitability, funding is diverted to different areas of the business to maximise sales.

Functions such as advertising, marketing, sales, operations and production of existing products or services are prioritised over the exploration of new ideas. As a result, investment in research and development (R&D) is reduced, innovation stalls, and the growth of established firms slows or even stops altogether.

"Firms go through evolutionary processes of selection and competition that determine who thrives and who withers into oblivion," say the authors of the research. "The capacity to continuously generate innovations is a primary source of sustained competitive advantage, but the risky nature of R&D activities results in financial constraints. R&D investment is therefore a key strategic factor for most firms."

The advantage of external resources

The significant investments needed for innovation often require resources beyond the internal cash flows of most firms. R&D is a costly and long-term investment which places significant financial strain on businesses.

And while reinvestment of profits in R&D to generate long-term competitive advantages seems the best strategic option, in general, those profits (or the debt acquired) seem to be destined mostly to consolidate the core business. The greater the profitability, the greater the concentration on the core.

Businesses that focus on new products or services by seeking external investment find more attractive prospects

In other words, the businesses that continue to focus on new products or services by seeking external investment will find themselves much more attractive prospects than those that focus on ploughing profits back into the business.

The energy exception

The study’s authors note that the size of the firm, and the sector within which it operates, impact on the profitability of innovation. The results do not apply to small firms, they stress, or those in consumer goods.

However, large firms in the energy sector also provided an interesting deviation from the results. "Innovation is important for traditional carbon energy producers, as the retrieval and refining of oil and gas require large investments in long-term R&D projects," say the researchers. "As most of the companies within our sample are privately owned, they are more profitable than traditional oil companies. This makes them more inclined to reinvest their profits in R&D to sustain their businesses."

The relationship between profitability and innovation is closer for firms that sell renewable energy than for those that sell fossil energy sources.

"The development of renewable energy is still dependent on developing adequate technology as this sector is not completely mature," explain the authors. "This could indicate that internal, profit-driven financing is a bigger priority for innovation in firms and industries in the early – and much more intense – stages of evolution."

Creating a competitive advantage

The results of the study have important implications for managers, and sector-specific studies can shed even more light on how to maximise financing for innovation.

According to the researchers, the moderating effect of debt financing on the relationship between profitability and innovation encourages managers to combine different sources of financing for innovation. The sectorial analysis also enables managers to weigh up internal and external financing depending on the area in which they operate.

"For the sectors of basic materials, manufacturing and construction, services, financial and property services, as well as technology and telecommunications, profitability is negatively related to innovation. The reason could lie in an additional layer of the selection process: allocating funding and resources to functions other than R&D hinders established firms from exploring new innovation."

The size of the firm, and the sector within which it operates, impact on the profitability of innovation

Future sector-specific studies, say the researchers, may want to delve further into the differences within sectors. For example, basic materials, manufacturing, and construction are defined as one sector, but while there may be innovative firms in manufacturing, the construction sector is characterised by less investment in R&D. "Our research focuses on the conditions under which competitive advantage can be generated through innovation, while further analysis of separate sectors will provide further nuance on the optimal financing mix."

While the researchers acknowledge its size and sector-specific limitations, they add: "Larger companies have easier access to external financing than small and medium enterprises, so caution is recommended when generalising the results to small businesses. How firms choose to finance innovation is crucial."

According to the researchers: "For most firms, profitability is negatively related to innovation, whereas firms in the energy sector are more innovative when they are profitable. Only for firms in the consumer-goods industry is there no relation between profitability and innovation."

Although it may seem counter-intuitive, the study indicates that large profitable firms (with the exception of the energy industry) tend to "become comfortable" and then reinforce their core businesses and reduce efforts in R&D.

Original research paper: Petra A. Nylund, Nuria Arimany-Serrat, Xavier Ferras-Hernandez, Eric Viardot & Henry Boateng, Alexander Brem. Internal and external financing of innovation, European Journal of Innovation Management.

This article was first published on 23 June by Esade.