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RESEARCH PRODUCT

EXPLORATION, EXPLOITATION AND INCENTIVES TO INNOVATE: THE DISCIPLINING ROLE OF DEBT

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Extant research suggests that when compared to equity, debt financing is less conducive to innovation activities. In this paper we challenge this view by suggesting that although equity sustains innovation by allowing risk-taking and experimentation, it may also encourage the pursuit of exploration at the expense of exploitation. Under these circumstances, the stricter governance associated with debt becomes important as it stimulates managers to shift resources towards exploitation in order to mitigate risk and improve short-term pay-offs. In support of these arguments our empirical analysis shows that, while leverage has a negative impact on standard measures of innovation quantity and quality, it is positively related to knowledge exploitation as measured by self- citation activity. We also find that firms are more likely to experience a significant increase in leverage when they are making poor use of their pre-existing knowledge stock. Finally, we document a positive interaction between leverage and ...