Small Innovators: No Risk, No Return

Abstract

We find that small innovators earn higher returns than small non-innovators for up to five years. We find no such innovation premium among large firms. A battery of tests shows that this innovation premium among small firms is explained by risk. Our findings, which are based on a simple measure to identify innovative firms, are in contrast with previous papers that attribute higher returns to innovation to investor underreaction. We argue that an innovation premium exists among small firms, but not large firms, because small innovators focus more on risky product innovation and rely more on organization capital, which amplifies their systematic risk. In addition, small innovators contribute significantly to the size premium. Overall, the higher cost of equity among small innovators has implications for their investment, growth, and capital structure decisions.