Applying for a patent appears to act as a signal to potential investors ... and leads to the availability of more capital.
Small firms often face early-stage problems in raising funds to support research and development of new products. In Patents as Quality Signals? The Implications for Financing Constraints on R&D (NBER Working Paper No. 19947), Dirk Czarnitzki, Bronwyn Hall, and Hanna Hottenrott confirm that small firms face R&D funding constraints, but they find that those pressures diminish when firms have applied for key patents that catch the attention of lenders and investors. Larger, more established firms are not subject to the same R&D funding constraints. They do not seem to benefit from the same "patent signals."
Many small firms rely on internal funding for R&D. This can hinder their ability to conduct R&D and to grow more generally. One of the challenges facing these firms when attempting to raise money, either from banks or from venture capital firms, is their lack of a business track record and in many cases the absence of collateral. Investors may also lack the detailed knowledge about the firm's technology that its managers possess. This creates a classic asymmetric information problem. Potential investors and lenders may feel that they do not have enough information to judge the firm's quality and potential value. This can lead to a high cost of capital for the firm, and in some cases can result in no capital market access at all. Applying for a patent can act as a "quality signal" to investors, who may be able to assess patent filings and determine their quality and potential value. Patenting can therefore relax capital constraints for smaller firms, particularly start-ups.
The authors explore this capital-constraint issue for small firms, but they also examine larger and more established firms to see if they also benefit from "patent signals." They analyze data from the European Patent Organisation and the European Patent Office, and on the financial experience of a large and broad sample of Flemish companies for the years 2000 through 2009. The results suggest that smaller firms, with fewer than 50 employees, with limited internal resources, experience R&D funding constraints that can hamper their growth and success. Applying for a patent appears to act as a signal to potential investors and lenders and leads to the availability of more capital. This is particularly true with firms where information asymmetries are especially high and collateral value is low.
The authors also find that larger, more established firms have more flexibility to pay for R&D with internal funds, and that they can also access more external funds from investors who have knowledge about their current and potential performance. These firms do not seem to benefit from "patent quality signals."
-- Jay Fitzgerald