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?
Financing 101
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.
Financing the Intangible Shift
Illustration by: Huzaifa Mohamedbha
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?
Financing 101
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:
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.
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OECD (2020), "SME loan shares: As a percentage of total outstanding business loans", in Financing SMEs and Entrepreneurs 2020: An OECD Scoreboard, OECD Publishing, Paris, https://doi.org/10.1787/d9cdc84f-en.
A lack of demand for debt financing
Debt as a financial instrument can be expensive, restrictive, and risky. This is particularly true for businesses whose income is uncertain and find it difficult to service debt. For young, intangible-intensive firms that operate in sectors where there is great uncertainty, debt simply might not make sense. As a result, differences in debt and cash holdings for these firms may be a reflection not of friction or barriers in lending markets, but the adoption of alternative financial strategies given available options and preferences.
According to data from Statistics Canada’s SFGSME, nearly 53 percent of firms did not apply for external financing in 2017, and of those, 91 percent said that financing was not required. As firm size increases, so too does the need for external financing. When firms were asked about the sources of financing used to start their business, 83 percent of SMEs used personal financing and 37 percent used credit from financial institutions. In knowledge-based industries (as defined by Statistics Canada), 90 percent used personal financing and only 22 percent used credit from financial institutions. While it is unclear how much of this can be explained by intangible-intensity alone, it is consistent with the fact that small, young intangible-intensive firms may have less desire for debt financing.
Are firms being rejected because of their intangible-intensity?
According to Statistics Canada’s SFGSME, in 2017 of the 26 percent of Canadian SMEs that requested debt financing, nearly 10 percent had their requests rejected. Rejection rates are highest for small firms (11.8 percent for firms with 1 to 4 employees) but decline as firm size increases. Almost no firms with 100 to 499 employees that sought debt financing reported being rejected (0.1 percent).
Source: Statistics Canada’s Survey on Financing and Growth of Small and Medium Enterprises (SFGSME), 2017
Why are firms rejected for debt financing? Of those firms that were denied debt financing, the most commonly cited reasons for being turned down include insufficient sales or cash flow (41 percent) and insufficient collateral (32 percent). This is consistent with our model of the market for finance in which lenders seek to reduce and manage risk by collecting more and better information about a firm’s ability to repay and the requirement of collateral in case of non-repayment. Again, this does not give us direct evidence that intangible-intensive firms are receiving fewer loans or more rejections, but it is consistent with the tyranny of collateral hypothesis. In some cases, intangible-intensive firms might not apply for financing even if they need it, because they anticipate rejection.
Source: Statistics Canada’s Survey on Financing and Growth of Small and Medium Enterprises (SFGSME), 2017
Alternative mechanisms and outstanding gaps
Owing to apparent frictions in the market, a number of alternative financing mechanisms have emerged that help more firms overcome barriers and secure funding, though many still slip through the cracks.
For intangible-intensive firms that can demonstrate many years of consistent positive EBITDA, cash flow-based lending is a promising option. Cash flow-based lending relies on information about a company’s past and future revenue prospects. In this case, lenders execute more rigorous and comprehensive ability-to-pay assessments of potential borrowers, including more attention to EBITDA, business plans, management expertise, and sector prospects. While this approach can ease the tyranny of collateral, in practice it means that mostly mature firms with many years of consistent revenue end up qualifying. In the SFGSMEs, it is clear that rejection rates for firms decline dramatically as firm size increases.
Firms that operate in the tech economy—in particular those that are scaling or exhibit the potential to scale—have access to a number of alternative forms of financing, from equity to alternative forms of debt. Equity investors purchase ownership rights in a company that gives them a share in the firm’s future profits. They are able to overcome information asymmetries through specialized industry knowledge, assuming control over a portion of the firm, as well as taking a portfolio-based approach investing in companies that can grow exponentially to cover losses. Firms that receive equity may also access venture debt or debt financing provided to firms that have already secured venture capital investments. In effect, these debt providers, such as Silicon Valley Bank, overcome limited information and manage risk by relying on the signals and backing of prominent venture capital firms.
Other debt providers (again, primarily focused on the technology sector) seek to overcome the tyranny of collateral by generating their own information about a firm’s ability to repay a loan. Clearbanc is a Canadian lender that provides loans to e-commerce firms. They partially overcome information asymmetries by using data and generating insights on the performance of the firm, as well as mitigate risk through revenue sharing agreements. Quantius is another Canadian lender that leverages a company’s intangible assets, specifically their IP as collateral to help secure a loan.
Despite the seemingly extensive financing options available to firms with mostly intangible assets, some gaps may still remain. We hypothesize that gaps are most stark for intangible-intensive firms that are not suitable for equity. They generate some revenue, but are not quite at a point of maturity to qualify for cash flow-based lending. An example of such a firm would be a relatively small marketing company that is earning revenue but not at the threshold required for cash flow-based lending, though still has an appetite for external financing.
How are we (or might we) address the gaps?
Recognizing the challenges, governments have introduced a number of state-backed financing schemes, ranging from dedicated funds to credit guarantees. South Korea, for example, has particularly well-developed programs geared towards the needs of intangible-intensive firms and also the highest proportion of outstanding loans to SMEs as a percentage of total loans of G7 countries. The Korea Development Bank (KDB) introduced techno banking which provides loans to companies actively involved in activities such as purchasing and commercializing IP. In addition, the Korea Credit Guarantee Fund (KODIT) was established to extend credit guarantee services “to enable promising small and medium-sized enterprises (SMEs) without enough collateral to obtain funds” to cover the default risk of borrowers. Since the introduction of this program, the proportion of loans going to SMEs appeared to steadily increase in Korea. As noted previously, in 2018 Korea led all other G7 countries when it comes to outstanding business loans held by SMEs.
BDC has also recognized the problem of credit constraints facing intangible-intensive firms. BDC introduced a $250 million loan program for firms that lack tangible collateral to make critical investments in intangible assets such as technology, intellectual property, R&D or employee training. Further, in response to the COVID-19 financial crisis, the government of Canada introduced the Business Credit Availability Program (BCAP), operating through BDC and Export Development Canada (EDC), to provide among other supports, guarantees of up to 80 percent of new operating credit and cash flow term loans of up to $6.25 million to SMEs. While not specific to intangible-intensive firms, the program will address issues associated with the tyranny of collateral.
COVID-19 and the intangible economy funding environment
As Canada continues to make the intangible shift, it’s critical to understand whether our existing mechanisms to support businesses can, not only keep up, but also drive the intangible economy towards greater growth and prosperity. If the tyranny of collateral continues to prevent intangible-intensive businesses from getting the funding they need to support innovation and growth, it could result in significant lost opportunities for those firms, workers, and the economy writ large.
Existing efforts from BDC represent critical steps to mitigating apparent frictions in the market for finance. Their lending envelope for intangible-intensive firms is possibly now more important than ever, but it is unclear whether it is enough or having the intended effects. Moving forward, it is important to monitor how it is used, what it achieves, and whether or not it needs to be expanded to address the needs of Canada’s intangible-intensive firms.
Current COVID-19-related support for business also alleviates some of the financing constraints for intangible-intensive firms, but they are temporary by design. It is unclear how, and to what extent, a firm’s ability to acquire financing will change in the short- and medium-term of post-COVID economic recovery. Some variables will remain largely unchanged, including a firm’s past performance, management teams, and available collateral. Therefore it will not alter loan eligibility but other variables will be substantially different. On the negative side, economic outlooks for many sectors are likely to be grim, thereby increasing risk of non-repayment, and lenders will have less cash to lend given their need to set aside money to cover an increase in loan defaults. On the positive side, interest rates are likely to remain low for some time and many lenders will be looking for good bets through which to balance their otherwise sluggish portfolios. In short, the funding prospects for intangible-intensive firms in a post-COVID world will be uncertain.
The larger risk is that funding uncertainty could further stall Canada’s intangible shift at a time when unlocking the potential of the intangible economy may be more critical than ever. If Canada wants to catch up to other economies in making intangible investments to realize the employment and prosperity benefits they bring, we will need to do a better job of addressing the unique challenges facing the intangible economy.
For media enquiries, please contact Nina Rafeek Dow, Marketing + Communications Specialist at the Brookfield Institute for Innovation + Entrepreneurship.
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