Patent as a Quality Signal in Entrepreneurial Finance: A Look Beneath the Surface

• DOI: http://doi.org/10.1111/ajfs.12211
• Date: 01 April 2018
• Author: Haitian Lu,Shi Chen,Wei Meng
• Published date: 01 April 2018

Patent as a Quality Signal in Entrepreneurial

Finance: A Look Beneath the Surface*

Shi Chen

College of Law, Southwest University of Finance and Economics, China

Wei Meng

School of Economics and Management, Beijing Jiaotong University, China

Haitian Lu**

School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kong SAR, China

Received 31 July 2017; Accepted 16 December 2017

Abstract

We examine the value of patents on Chinese firms’ access to venture capital (VC). We find

that the patent applications (grants) of firms significantly increase their likelihood of obtain-

ing VC funding in the following year(s), particularly for high-quality patents in high-tech

industries. Depending on investment, patent quantity significantly improves the size of VC

investment and firm valuation. This effect is pronounced in first-round investment, strong

intellectual property protection regions, during periods of loose monetary policy, and state/

corporate VC. Overall, we support the use of patent as a quality signal in attracting entrepre-

neurial finance outside the US and warrant the conditions it holds.

Keywords Patent; Venture capital; Signaling; Innovation

JEL Classification: G24, L26, O39

1 Introduction

Empirical evidence from the US suggests that patenting activities help entrepreneur-

ial firms gain access to venture capital (VC) (Cao and Hsu, 2011; Conti et al., 2013;

Hsu and Ziedonis, 2013; Hoenig and Henkel, 2015; Farre-Mensa et al., 2016).

Young and high-growth firms that seek external financing should communicate

*We thank the guest editor, Xuan Tian, and anonymous referees for their helpful comments.

This work was supported by the Chinese Fundamental Research Fund for Central Universities

(JBK170106) and the National Natural Science Foundation of China (#71503225 and

#71573174).

**Corresponding author: School of Accounting and Finance, The Hong Kong Polytechnic

University, Hung Hom, Kowloon, Hong Kong. Tel: +852-2766-7065, Fax: +852-2264-1809,

email: haitian.lu@polyu.edu.hk

Asia-Pacific Journal of Financial Studies (2018) 47, 280–305 doi:10.1111/ajfs.12211

280 ©2018 Korean Securities Association

quality issues to investors. When making investment decisions, venture capitalists

also seek credible quality signals associated with the unobservable growth potential

of the firm (Stuart et al., 1999). According to Spence (1973), patents conform well

to the conceptualization of a “signal.” They are costly to obtain, certified by the

government for their novelty and non-obviousness, and are exclusive property

rights with intrinsic value.

The value of patents in helping entrepreneurial firms finance their growth is an

important issue, but only a few studies have examined the conditions under which

this positive effect holds. These conditioning factors are crucial because patents are

costly to obtain, not necessarily associated with return, and VC differs in terms of

expertise and objective functions. In certain regions, the strategy of using patents as

a signal is more successful at specific stages of development and macro-economic

periods in attracting certain types of VC. Existing studies on patent signal focus on

the US, but whether these findings extend to other VC markets requires explo-

ration. This study presents novel evidence from China, which is one of the world’s

largest technological markets and a hotspot for international VC.

China is an important market and offers a unique laboratory for this test.

1

In

2016, the Chinese patent office received over 1.1 million patent applications, which

was almost equal to the total applications received in the US, Japan, and Korea

combined. Since 2010, non-US investments accounted for approximately half of

global VC investments (of which China is the largest importer); this period also

marks a considerable improvement in the quality of VC investment data outside

the US (Da Rin et al., 2011). As part of an economy in transition, the different

regions of China are undergoing a process of heterogeneous market development.

The VC market is characterized by foreign and domestic (state and private), inde-

pendent, and corporate players. Finally, the Chinese VC industry is volatile as a

result of global economic conditions and domestic political mandates. These institu-

tional settings therefore provide unique variations that can be exploited.

We start by testing whether the patenting activities (applications and grants) of

Chinese firms are important in attracting VC investment. By using data on VC

investments and patenting activities of publicly traded Chinese firms from 1998 to

2016 and after conducting propensity score matching (PSM), we find robust evi-

dence that the submission of patent applications or grants in the current year posi-

tively predicts firms’ likelihood of obtaining VC funding in the following year(s).

Depending on VC investment, a large number of patents is associated with

increased investment and firm valuation. Further tests indicate that this positive

relation depends on patent quality.

What explains this association? We hypothesize that a patent can act as a good

signal if it can reduce information friction between VC and entrepreneurial firms.

Information asymmetry is likely to be high when the firm is private and is seeking

1

We provide details of the institutional settings in the online appendix due to article length

limit.

Patent Signal and Entrepreneurial Finance

©2018 Korean Securities Association 281