Participatory Loans and Innovation in Smes: Rethinking the Public Funding of Innovation Capabilities

There is a long research tradition around the existence of underinvestment problems that might arise in R&D and, more generally, innovative activities. These problems might become significant barriers to innovation in SMEs, due to the relationship between access to finance and production scale. However, previous literature is consistent with the hypothesis that innovative capabilities are not necessarily a matter of scale, then the need for new ways of financing innovative activities in SMEs. In this paper we analyze the impact of a new experience of public funding for SMEs innovative projects on the performance of firms (the participatory loan), where lender receives a variable interest rate determined by the evolution of company profits, and the selection criteria of innovative projects incorporate atypical attributes of firm related with the concept of intellectual capital management (such as the degree of innovation in the business model, or the experience of the management team in its sector of activity). We estimate the relative increase in productivity associated with the maturity of the project financed, using panel data on a sample of 387 Spanish companies. Results suggest that firm’s productivity can be partially explained by the development of the participatory loan projects, indicating a satisfactory selection of projects. The implications for policy making are straightforward, since these kinds of instruments might improve the incentives for more accurate selection of projects in public funding institutions (for example, by promoting the elaboration of intellectual capital reports), and ease the effects of uncertainty on private funding. The influence of production scale on the evolution of innovation The involvement of public sector in R&D activities is widely accepted in society, in contrast to its participation in other areas of economic activity (trade, production, etc.). Scientific literature has highlighted potential “market failures” generating lower volumes of R&D investment than those socially desirable (Nelson, 1959; Arrow, 1962), due to uncertainty about the appropriability of results from innovative activities. This has been understood in modern society, so that much of the current scientific research and other activities associated with innovation are funded by the public sector. In this context, the ability of the public sector to choose successful projects is a central issue in efforts to step out of this market failure. From an evolutionary perspective (Loasby, 2002), the economic process can be seen as a changing system, where the generation of variety takes the form of innovation plans, and only some of them are "adopted" by the environment through certain selection mechanisms, reaching the implementation phase. In this sense, the study of these specific project selection mechanisms (formal or informal, public or private) that coexist in the system should be an intermediate step in the explanation of the historical process of something like an innovation system. Specialized literature as highlighted the relationship between access to finance and production scale. For example, Martinelli (1997) observes that large firms face lower interest rates than small firms, and suggests that reputation building by the firms allows markets to overcome these difficulties over time. Czarnitzki and Hottenrott (2011) found that smaller firms suffer more from constraints in the access to external capital on R&D investment than larger firms. Small firms, they suggest, may have disadvantages because they cannot exploit scale economies, and have fewer overall physical assets that could serve as collateral compared to large capital intensive companies. However, previous literature is consistent with the idea that innovative capabilities might not be matter of scale, or at least not everywhere. Acs and Audretsch (1987), found that small firms tend to have a relative innovative advantage in industries which are highly innovative, whereas large firms tend to have a relative advantage in industries which are capital-intensive and produce a differentiated good. Similarly, Damanpour (1992), analyzing scientific results relating size and innovation, detected that size is more positively related to innovation in manufacturing organization. A more recent review of scientific literature on the relationship between size and organizational innovation shows mixed results (Lee and Xia, 2006), and some studies found a negative relation with regards to innovation performance (see Becheikh, Landry and Amara, 2006). In short, scientific literature suggests that funding for innovation is more linked to production scale than to innovation capabilities. This could be interpreted as a market failure in financial system due to its inability for selecting successful innovative projects. Moreover, the existence of these barriers for small firms is consistent with the idea that production scale of innovator influences the selection criteria in the evolution of knowledge of the economic system. The soft part of the organization Literature on intellectual capital management has emphasized the importance the soft part of the organization (intangible assets, as they are sometimes called, such as the quality and capacities of the employees and managers, previous experience in innovative projects, managerial flexibility, networks with clients or other firms, reputation, etc.) on innovation performance (Subramaniam and Youndt, 2005; Chen and Huang, 2009; Alpkan, et al., 2010). Other authors have stressed that reporting this intellectual capital might influence the decisions of financial analysts (Alwert, Bornemann and Will, 2009). According to the Report to the European Commission of the high level expert group on Reporting Intellectual Capital to Augment Research, Development and Innovation in SMEs (RICARDIS), an IC Statement [i.e., intellectual capital report], if properly used, can not only help SME’s to explain why finance is needed and how it will be used, but also provide a basis for assessing the degree of risk and uncertainty surrounding the finance proposal. This is the key to the evaluation of whether the finance proposal is best suited to debt, equity or a mixture of the two (EC, 2006:81). The case of participatory loans is interesting because it allows discussing a selection mechanism that explicitly takes into account this soft part of the organization. The public institution that delivers these loans, whose basic characteristic is that the lender receives a variable interest rate determined by the evolution of firm's profits, is the National Innovation Company (ENISA), from the Ministry of Industry, Energy and Tourism of Spain. Their selection criteria take into account issues such as the viability of the project, the degree of innovation in the business model, or the experience of the management team in its sector of activity. The type of firm receiving the loan depends to a large extent on the line of action of ENISA through which the credit has been requested. For example, the line of credit for technology-based firms (EBT line) is intended to support companies that carry out projects that result in a technological breakthrough in the development of new products, processes or services: The ENISA line tries to capture newly created companies submitting projects with an innovative business model. And, finally, SME line aims to support projects aimed at improving competitiveness of the firm. Many studies have examined the impact of R&D and innovation activities on the productivity of the firm (Mansfield, 1965; Minasian, 1969; Griliches, 1980; Terleckyj and Levy, 1983; Griliches and Mairesse, 1984; Sassenou and Mairesse, 1991; Hu, 2001; Parisi, Schiantarelli and Sembenelli, 2006; Mansury and Love, 2008; Hall, Lotti and Mairesse, 2009; Coccia, 2010; Cucculelli and Ermini, 2012). These studies generally focus on sectoral analysis (manufacturing, services, chemical industry, research and development sectors, etc.), and most of them analyze the impact of variables associated with innovation activities (R&D in most of the cases) on the residual factor of the production function of the firm. From the methodological point of view, our study takes inspiration from this previous literature by assuming that the activities related to innovation projects result in changes in the production function of the firm. However, the sample used do not corresponds to a sector of the economy, but to a group of firms that are (or have been) part of a concrete experience of public funding for innovative projects in SMEs: the participatory loan. The objective of this study is to analyze the relationship between productivity of the firm and the “maturity” of the project funded. Data and methodology The study was performed with panel of data from 387 companies receiving participatory loans. The data includes information such as the date of grant and the amount of credit, line of credit and accounting data received from the balance sheet and the income statement. Accounting data is available for at least three years for each firm in the period 2004-2012. This yearly information might be prior to the date of grant of credit (because ENISA asks for 1 This information was provided to this research team, under the Agreement between the National Innovation Company (ENISA) and the UAM-Accenture Chair in Economics and Innovation Management, through the Foundation of the Autonomous University of Madrid. previous accounting data to all candidates). This characteristic of our data will be important in shaping our explanatory variable. The basic framework for our analysis is the production function of the firm: This function is conventionally interpreted as the logarithm of a Cobb-Douglas function, where is output, measured by the natural logarithm of sales for firm i at time t; are the inputs of the production function (assets or number of employees, both in natural logarithm); is a variable related to the concept of knowledge-based capital (OECD, 2013), among which may be the R&D or innovation activities, the use of ICTs in business processes, relationships with external partners, etc.; is a constant; y are specific effects of firm i in period t, respectively; and, finally, is the error term. The focus is on analyzing the significance of the estimates of the coefficient , regardless of the observable variable that takes the place of . Since ENISA finances innovative viable projects aimed at improving the competitiveness of the company, the variable will be maturation time of the project of firm i at time t, measured by the number of years since the date of grant of participatory loan. With this framework we test the hypothesis that the value of the production function is higher for later stages in the implementation of the funded project, regardless of the scale of production of the company, the type of credit line, the year and the productive history of the company (captured by the individual effect of panel data model). The models were estimated by panel data techniques. Given the fact that we have firms reporting sales equal to zero in some periods (i.e. we have a censored endogeneous variable), we use a random-effects tobit regression. The objective of the econometric analysis is to study, for alternative specifications, the statistical significance of the relationship between the maturation of the project funded by ENISA and productivity.