Given the current turbulence in the economy, it seems obvious to state that the financing available to start-ups is extremely volatile. After all, most are funded through equity investments or profits –- both of which have dried up over the past year.

However, just a few years ago, firms with hefty bank balances were often seen as hoarding cash, thus diminishing shareholder value. That wasn’t the case, however, says Bruce Petersen, an economics professor at Washington University. Petersen also is a co-author of several studies on the ways in which young companies finance R&D.

In a forthcoming study, “Cash Holdings and R&D Smoothing,” Petersen and co-author James Brown from Montana State look at the correlations between R&D spending, stock and debt issuances, cash flow, and cash holdings at thousands of publicly traded manufacturing firms between 1970 and 2006. Over the period, both cash holdings and R&D spending grew steadily, while cash flow and financing from debt and stock bounced around. In 2001, for instance, net stock issues show a deep dive, while R&D spending took a much lighter hit. What’s more, neither cash flow nor debt finance made up the gap.

Instead, the firms drew down their cash holdings to continue their R&D efforts -– in effect, smoothing their research expenditures. In fact, the typical small firm held enough cash to cover about two years’ worth of R&D spending, Petersen says. “They recognize how volatile access to public equity is,” he notes. Moreover, R&D is a difficult expense to chop even when times are tight –- once a project has been given a green light, it’s probably key to the company’s overall strategy, and backing off of it doesn’t make sense.

The upshot? Young, research-intensive firms with hefty cash holdings are better able to continue with their R&D investments even when other sources of financing tighten. This should enhance, rather than hurt, their value. ###