Why debt play an important role in innovation

What is it about?

This paper proposes a theory of capital structure based on March’s (1991) exploration/exploitation framework. The idea is that although equity encourages exploration, debt stimulates exploitation by imposing cash flow obligations on the firm. Hence a mix of debt and equity keeps innovation along the optimal trajectory while preventing the balance from swinging too far in the direction of either too much exploration or too much exploitation. Empirically, a key relationship we demonstrate is that debt is positively related to self-citation activity which reflects the extent to which a firm exploits its own knowledge in further innovative efforts. Another key idea of the paper is that in the absence of proper incentives, it is not just exploration but also exploitation that becomes vulnerable within firms. This runs contrary to received wisdom that it is only exploration that suffers within firms.

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Why is it important?

For managers and capital providers, this paper attempts to dispel the notion that debt is detrimental to innovation. A judicious use of debt (and debt like instruments) acts as a stimulus to exploit knowledge and maximize the firm’s innovative output in the long run. Hence neither should managers be hesitant to take on debt, nor should markets be hesitant to provide debt to firms that are R&D and technologically intensive.

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