Bankruptcy recovery rate and small businesses' innovation

Small businesses often face a high risk of bankruptcy and harsh financing conditions, which can hamper them to engage in innovation. This paper investigates whether a bankruptcy system that guarantees a good recovery rate for creditors in case of firms’ liquidation stimulates small businesses’ innovation investments through lower interest rates and therefore easier access to credit. With the help of a borrower-lender model we derive insights about the interactions between bankruptcy recovery rate, borrowing interest rates and firms’ investments in innovation. The model gives theoretical underpinnings for a subsequent empirical analysis. By using a cross-country sample of micro (1-9 employees)-, small (10-49 employees)-, and medium (50-249 employees)-sized enterprises (MSMEs), our study provides three main results. It shows that an increase in the bankruptcy recovery rate a) is positively associated to MSMEs’ investments in innovation (investment effect); b) reduces the share of MSMEs that are credit constrained because the cost of borrowing is too high (constraint effect); c) reduces the interest rates dispersion for high profitable MSMEs (dispersion effect). Overall, our findings suggest that improving creditors recovery rate can help promoting the innovative behaviour of small businesses through easier financing conditions.