Capital Structure and Innovation Trajectory: The Role of Debt in Balancing Exploration and Exploitation

We examine the role of debt as a governance mechanism in balancing exploration and exploitation. We argue that while equity is conducive to uncertain exploration critical for innovation, debt provides countervailing incentives for engaging in exploitation by imposing cash flow obligations and the threat of bankruptcy. As a consequence, debt becomes a vital instrument in directing innovation along the optimal trajectory, while preventing the balance from shifting too far toward suboptimal exploration. To support our arguments, drawing on patent data, we first demonstrate that a firm’s leverage is positively related to knowledge exploitation activity as reflected in its self-citations. Next, we show that firms that have potentially engaged in suboptimal exploration, as manifest in underutilized stocks of proprietary knowledge, are likely to experience leverage increases in the short run, and these leverage increases in turn result in subsequent increases in self-citations. These effects are consistent with firm value indicating that equity holders value the role of debt in stimulating exploitation. Our study draws attention to the complementary roles of equity and debt as governance mechanisms in balancing exploration/exploitation, while outlining the role of debt in innovation in greater depth.