Do Banks Value Innovation? Evidence from US Firms Bill Francis, Iftekhar Hasan, Ying Huang, and Zenu Sharma * This study evaluates how innovation within companies alleviates the information asymmetry problems in relationship lending. We hypothesize that patenting activities could reveal favorable private information and, hence, reduce the information asymmetry between innovative borrowers and banks. Using a sample of US patenting firms from 1987 to 2004, we show that borrowers with higher innovation capability (revealed by having more patent applications, higher research & development (R&D) productivity, or higher-quality patents) enjoy lower bank-loan spreads and better nonprice-related loan terms. Our evidence further suggests that the information benefits of patenting activities on loan spreads is more pronounced for small or less R&D-intensive firms. Innovation has long been documented as the driving force for economic development and firm growth. Schumpeter (1942) argues that technological competition is the major form of competition in capitalist economies and sets the stage for continuing change. Many also suggest that innovation produces new business opportunities and accounts for productivity growth (Abramovitz, 1956; Solow, 1957). In addition, prior studies find that investments in innovation lead to higher future earnings (Ali, Ciftci, and Cready, 2008) and positive long-term abnormal operating performance (Eberhart, Maxwell, and Siddique, 2008). However, researchers in economics and finance argue that innovation is difficult to finance in a freely competitive market (see Hall, 2005) for a review). Innovative firms create wide infor- mation gaps between insiders and capital markets because the idiosyncratic (Holmstrom, 1989), intangible (Eberhart et al., 2008), and entrepreneurial nature of their research & development (R&D)-intensive efforts make them reluctant to disclose information. Confidentiality is important in the research process (Bhattacharya and Ritter, 1983; Carpenter and Petersen, 2002). The gap gets even bigger when considering that companies are uncertain what the returns on their R&D investments will be (Nelson, 1959; Arrow, 1962; Chan, Lakonishok, and Sougiannis, 2001) and face moral-hazard problems when entrepreneurs change their postcontract behavior (Carpenter and Petersen, 2002; Hall, 2005). Thus, evaluating the benefits and risks of innovation and deter- mining the value of innovating firms may require access to detailed confidential knowledge of a firm and its industry, which is often not available or is difficult for outside investors to obtain. This is why investors often charge a “lemon premium” to compensate for the risk associated with information-asymmetry problems when financing innovative firms. In turn, innovating firms are often keenly interested in mitigating their information asymmetry problems to reduce their cost of capital. The authors wish to thank Bill Christie (Editor) and an anonymous reviewer for helpful comments. Usual caveats apply. ∗ Bill Francis is a Professor of Finance at Rensselaer Polytechnic Institute in Troy, NY. Iftekhar Hasan is a Professor of Finance at Fordham University in New York and Scientific Advisor at Bank of Finland. Ying Huang is a Rating Analytics Associate at Standard and Poor’s in New York, NY. Zenu Sharma is an Assistant Professor of Finance at Long Island University, C.W. Post, NY . Financial Management • Spring 2012 • pages 159 - 185