# 1 Introduction

In their seminal work on finance and growth, Rajan and Zingales (1998) were able to show that industries more dependent on external finance grow faster in countries that are more developed financially. More recently, Guiso et al. (2004a) find that the smaller the firm, the stronger this association between financial development and growth. In another paper, using regional data from Italy, Guiso et al. (2004b) find that regional financial development is more beneficial to the growth of smaller firms. Levine et al. (2006) show that industries which for technological reasons have a larger share of small firms grow faster in economies with well-developed financial systems. Aghion et al. (2007) report that there is greater entry of small firms relative to large firms in countries at higher levels of financial development.

This suggests that financial development does not affect firms of different sizes equally, and that it matters more to the growth of small firms. However, our understanding of this differential effect is limited. Why are smaller firms more sensitive to financial development? It is possible that the informational asymmetries which cause financial market failures also cause these failures to hurt small firms more than large firms. Lenders might know less about smaller firms because they are more opaque, or because given the small loan size, it is not profitable to spend resources on acquiring information about small firms and monitoring small loans. Another explanation is that financial innovations reduce the need for collateral, affecting smaller firms disproportionately because they have fewer tangible assets to put up as collateral.

Among the activities of a firm, innovation is most susceptible to adverse selection and moral hazard. This is because the innovator is likely to have much better information about the chances of success than potential investors, and the latter are unlikely to have the knowledge necessary to effectively monitor the research project.<sup>1</sup> Another key feature of investment in innovation is that much of it goes into intangible assets, such as the specialized knowledge embodied in researchers.

A stylized fact in the literature on innovation by firms is that the smaller the firm, the less likely it is to engage in research and development, and that among firms engaged in R&D, the amount spent on innovative activities rises with firm size (Cohen and Klepper (1996)). Yet, studies which estimate the productivity of R&D indicate that innovations produced per dollar of R&D are higher in smaller firms.<sup>2</sup> Acs and Audretsch (1991a) report that small firms contribute more than twice as many innovations per employee than do large firms, while Plehn-Dujowich (2006) finds that on average, smaller firms obtain three times more patent citations per dollar of R&D. This association of firm size with rising investment and falling productivity in R&D suggests that there is underallocation of R&D investment to small In addition, Hall (2005) reports evidence for the presence of liquidity constraints in a number of studies of R&D investment by firms in various developed countries. Her survey of research on the venture capital industry indicates that the industry is concentrated precisely where innovative startups, which are mostly small firms, are most active, and that in spite of considerable entry into the industry, returns remain

> 1In a recent paper, Herrera and Minetti (2007) show that the length of a bank’s relationship with a firms is positively associated with more R&D by the firms. Interpreting the relationship length as a proxy for the bank’s information on the leads them to conclude that bank’s information matters to innovation.

> 2Cohen and Klepper (1996), Bound et al. (1984), Acs and Audretsch (1991b), Acs and Audretsch (1988).

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