Syncing Innovation to Avoid Sinking: Supplier Response to Customer Covenant Violations

Financing frictions increase customers’ marginal net benefits from technology sharing with suppliers as seeking supplier cooperation and reducing costs become significant concerns, thereby increasing collaboration and supplier innovation. Using U.S. data, we find that suppliers of customers violating loan covenants become more innovative, specialize in niche areas, and exhibit greater tendencies to cite and coordinate their own innovation with the customer’s. These gains are stronger when suppliers have greater financing flexibility and when customers are highly specialized and trustworthy. In addition, innovative suppliers seem to thrive following customer covenant violations. Overall, our evidence indicates that customer financing frictions shape their suppliers’ relationship-specific investments and innovation.