Financing Innovation with Innovation

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