Investment in innovation is characterized by uncertain and often intangible outcomes, knowledge spillovers as well as information asymmetries between managers vis-à-vis lenders and investors. These properties affect the financing of innovation. Financing constraints occur when firms' innovation activities are affected negatively by the lack of internal financing and constrained access to external financing, including high cost of debt or a shortage of equity. The extent to which a firm's innovation activities are affected by financing constraints depends on its size, maturity and the nature of its innovation investments: Smaller and younger firms as well as firms pursuing more radical innovation projects are more likely to face financing constraints than larger, older or incrementally innovating firms.
Subsidies for research and development (R&D) are an important innovation policy tool. The economic rationale behind R&D subsidies is that private sector R&D is lower than socially desirable due to positive externalities and financing constraints. R&D subsidies are often designed as direct, project-based grants. Companies apply for them at public funding bodies who administered applications and make funding decisions on a case-by-case basis. An alternative way of granting R&D subsidies is through tax credits. Research shows that both forms of R&D subsidies can trigger additional R&D, but the evidence also suggests that the extent to which R&D subsidies initiate and expand R&D in recipient firms depends on the characteristics of the firm and the type of project that is subsidized.