Financing innovation in Latin America

Economic theory has shown that firms operating in competitive markets tend to achieve suboptimal levels of research and development (R&D) investment (Arrow 1962; Hall 2002; Hall and Lerner 2010). The main argument is that the knowledge of producing new products and processes, which is the primary output of R&D, is non-rival. To the extent that knowledge cannot be kept secret, the investment benefits will not be fully appropriated by the firm carrying out the investment. This will lead to an R&D underinvestment, despite the fact that imitation is costly.

On the other hand, R&D differentiates from ordinary investment (Hall 2002; Hall and Lerner 2010). First, human capital is very different from investment in physical assets, such as inventory goods or plant and equipment, in the sense that it may be partially lost as some highly-trained employees leave or are fired from the firm. Second, R&D investment is associated with a high degree of uncertainty regarding its final outcome and economic retribution. This state of uncertainty tends to be particularly severe at early stages of an investment project, so that traditional valuation methods render inappropriate the assessment of profitability.

Alternatives ways to mitigate the underinvestment problem are an intellectual property system, government support of R&D, tax incentives, and encouragement of research partnerships. Such interventions are usually justified by the fact that the social return to R&D exceeds its private level. However, when the innovator and financier are different entities, there is an additional gap: the discrepancy between the private return and the cost of capital. Regarding this funding gap, Hall (2002) concludes that (i) venture capital only partly mitigates the high cost of capital faced by small and new innovative firms; (ii) large firms tend to rely on internal funds for financing innovation; and, (iii) venture capital does not solve the funding gap completely, particularly in countries where public equity markets are not highly developed.

The purpose of this study is to contribute to the extant literature by examining how private companies fund innovation and R&D activities in Latin America. The information source is the World Bank’s World Enterprise Survey 2006 and 2010. Specifically, this study seeks to identify whether innovative companies exhibit financing patterns different from those of non-innovative ones. In addition, this study aims at gauging the association between innovation and firm features, such as age, size, female participation in ownership, and foreign ownership, among others.