Canada’s post-pandemic economic recovery needs to be more than a return to the pre-COVID-19 status quo. We need to build a strong foundation for long-term growth among the intangible-intensive firms and sectors that make outsized contributions to economic prosperity—something we have long neglected. A key piece of that foundation will be identifying new models of financing. Firms whose value is found in intangible assets, like data, brands, firm-specific knowledge and skills, and IP, appear to face barriers to accessing debt financing largely because of a lack of collateral. If this is in fact the case, we need to remove the barriers to ensure that Canada’s intangible-intensive firms can play a leading role in recovery and long-term growth.
Prior to the pandemic, we sought to determine the extent of the intangible finance challenge and what, if anything, can be done to address it. We assessed the available literature and data and conducted interviews with academics, firms, and financial institutions. While it is extraordinarily difficult to quantify the magnitude of the financial challenges faced by intangible-intensive firms, and thus the impact it might have on innovation and growth, they are apparent gaps in the market for finance for intangible-intensive firms that need to be examined and addressed.
What follows is our thoughts on the financing challenges faced by these firms, what’s being done about it, where issues may still exist, and where we need more insight.
The challenges of financing in an intangible economy
Intangible assets have become increasingly significant contributors to innovation and economic growth. Over the past five decades, investments in intangibles in Canada have grown faster than tangibles, reaching $134.3 billion in 2016. This intangible shift is associated with higher productivity and growth, but Canada lags other countries and relative investments in intangibles have been declining since the early 2000s. Even before COVID-19, Canada had not achieved its intangibles-driven economic potential. Until we address key barriers, our post-pandemic recovery will be more of the same.
A much discussed barrier facing intangible-intensive firms in Canada is access to financing. Money is an essential input into innovation and growth. At a firm level, access to finance can support critical investments in productive assets such as software and R&D to help promote innovation and improve productivity. Among all firms in Canada, nearly 1/5 report access to internal or external financing as an obstacle to innovation. This rises to 1/4 for firms in manufacturing, information and cultural industries, and professional, scientific and technical services. When 1/4 or 1/5 firms are financially constrained, the innovation and growth opportunity cost is substantial.
Are these funding challenges more severe among intangible-intensive firms? If so, why? What is it about the interaction between intangible-intensive firms and conventional sources of funding that leaves them less well-off? Why might financiers struggle to measure and appropriately price lending risk when faced with intangible-intensive firms? And what, if anything, can be done to overcome this barrier to realizing the innovation, employment, and prosperity benefits of the intangible economy?
There are a variety of financial mechanisms to get money in the hands of firms that need it, while ensuring that those who give it reap some kind of return. These include government and foundation grants, equity, loans, and money lent or given to entrepreneurs by supportive family and friends. The most common and conventional form of financing for Canadian firms is debt. In 2017, according to Statistics Canada’s Survey on Financing and Growth of Small and Medium Enterprises (SFGSME), 47 percent of Canadian small and medium-sized enterprises (SMEs) sought external financing. Of those, 26 percent sought debt financing, versus 4 percent that sought government financing and 1 percent that sought equity. But how exactly does debt financing work?
In general, financiers identify borrowers who are likely to repay loans with interest over a set period of time. The challenge, however, is that it is not immediately clear which firms are more or less likely to repay the loans. Different firms pose different levels of risk. As such, lenders conduct systematic assessments to identify, price and manage risk appropriately. More specifically, financiers generally conduct risk and credit worthiness assessments along two variables:
- Ability to repay. Lenders want their money back with interest so they need to know the likelihood of that happening with a potential borrower. They examine a firm’s historical financial performance, often using a measure known as EBITDA (earnings before interest, taxes, depreciation, and amortization). Firms with positive EBITDA over a sustained period of time are viewed more favourably. Additionally, lenders look at credit history, quality of firm management, experience and performance, current business plans, and general industry and economic conditions to determine a firm’s likelihood of repaying.
- Collateral. Recognizing that some risk will still exist even when the prospects for repayment appear favourable, lenders also examine a firm’s potential collateral or the assets they can seize and liquidate in the case of non-repayment. Many lenders will offer loans to firms whose ability to repay might be unclear as long as collateral is present. While offering collateral is commonly regarded as a burden or risk for borrowers, the fact that collateral can be offered facilitates access to more money at cheaper rates than they might otherwise be able to secure. In short, collateral lubricates the market for finance to the benefit of both lenders and borrowers, especially in areas where risk assessments are difficult to make.
Simply put, where information on the ability to repay and/or collateral are limited, interest rates on loans will be higher and the amount of money offered will be lower, if available at all.
Tyranny of collateral
While collateral can lubricate the market for finance, not all firms who need money have the necessary collateral. Tangible assets such as buildings and machinery serve well as collateral because they are easier to seize, price, and liquidate if the borrower defaults. By contrast, intangible assets such as brands, data, and knowledge have limited or no utility as collateral. Investment in intangible assets are often sunk, meaning that they have limited market value outside of the firm that made the investment. As a result it’s often difficult, if not impossible, for a lender to price and liquidate a company’s intangible assets. For example, a customer list might have immense value for a given company, but no value to banks who want saleable assets, not businesses to operate.
This generates what has been called the tyranny of collateral. Recent evidence suggests that a firm’s inability to use intangible assets as collateral contributes to credit constraints. Intangible-intensive firms, particularly small and young firms, hold less debt and more cash than other firms (see Aghion et al., 2004, Falato et al., 2018, Haskel, 2020). A study of 3,500 non-financial Canadian firms from 1980 to 2006 showed that companies are becoming less indebted and holding a greater proportion of their assets as cash. The study concludes that a firm’s increased cash holdings are correlated with both a decrease in their overall size and an increase in R&D expenditures. Similarly, a 2002 study of Canadian firms who survived their first 10 years of operation showed that small firms in knowledge-intensive industries, or those that devote substantial investment in R&D, exhibit less debt-intensive structures and were more likely to finance activities using retained earnings.
Other studies have shown that in light of the increasingly intangible nature of assets held by firms across the economy, banks have moved away from offering loans to businesses and towards more real-estate holdings. One study showed that in the US between 1984 and 2016, the composition of bank loan portfolios dramatically shifted away from commercial and industrial loans (falling by 1/3) towards real estate holdings, which more than doubled. They conclude that a firm’s rising investment in intangible assets—and the associated challenges of lending to intangible-intensive firms—explains close to 30 percent of the decline in commercial and industrial loans in the US since the mid-80’s.
Lending to Intangible-Intensive Firms in Canada: What we know and don’t know
Theoretically, and evidently in other jurisdictions, the tyranny of collateral makes it harder for intangible-intensive firms to secure loans. Direct evidence of the effect of collateral constraints for these firms is scarce and spotty, but what is available appears to show that Canada is a laggard compared to international peers when it comes to loans for SMEs. However, it is unclear whether what looks like a credit constraint due to insufficient collateral might instead be explained by other factors, such as a lack of demand for debt among firms. What can we say about these various possibilities?
Canada is an outlier when it comes to loans to SMEs
Among G7 countries for which there are data, Canada has the lowest proportion of outstanding business loans held by SMEs at 11.7 percent in 2018, down from 12.5 percent in 2017. This was also the lowest among OECD countries. Arguably, Canadian lenders have more difficulty than those in peer countries assessing and accepting risk among SMEs, resulting in a higher proportion of Canadian SMEs facing financial constraints on innovation and growth. Alternatively, the data may also indicate that larger firms have increased their appetite for external financing—and thereby constitute a higher proportion of all debt in Canada—and/or that Canadian SMEs seek less debt financing.