Financing Innovation with Innovation

This paper documents that firms increasingly finance innovation with their stock of innovation, measured as patents. We refer to this behavior as financing innovation with innovation. Drawing on patent collateral data from the US and China, we first show that (1) in both countries the number and the share of pledged patents as collateral have been rising steadily over the past decades, (2) Chinese firms, however, employ patents as collateral on a smaller scale and lower intensity than US firms, (3) firms increase their borrowing and innovation activities once they start to engage in patent collateral. We then construct a heterogeneous firm general equilibrium model featuring idiosyncratic productivity risk, innovation capital investment, and borrowing constrained by patent collateral. The model emphasizes two frictions that hinder the use of patent collateral: fixed inspection costs and low liquidation value of patent assets. We parameterize the model to firm-level data in the US and China respectively and find that both frictions are significantly more severe in China than in the US. Finally, counterfactual analyses show that the gains in innovation, output and welfare from enhancing the liquidation value of patent assets in China to the US level are more substantial than reducing the inspection costs