Innovate to Survive: The Effect of Technology Competition on Corporate Bankruptcy

By Eisdorfer, Assaf; Hsu, Po-Hsuan | Financial Management, Winter 2011 | Go to article overview

Innovate to Survive: The Effect of Technology Competition on Corporate Bankruptcy


Eisdorfer, Assaf, Hsu, Po-Hsuan, Financial Management


This paper establishes a strong relation between technology competition and corporate bankruptcy. Using detailed firm-level patent data, we show that: 1) the capability of firms to innovate predicts future bankruptcies better than the typical measures such as Z-score and credit rating, 2) technology-related bankruptcies are less sensitive to the business cycle and industry success, and 3) firms that go bankrupt as a result of technology competition experience larger declines in earnings and stock prices.

The finance literature has a long history of analyzing corporate bankruptcy. This includes development of bankruptcy prediction models, assessment of bankruptcy costs, and analysis of the association between bankruptcy and macroeconomic conditions. While many bankruptcy studies cover a large set of accounting- and finance-based data, no study has examined directly the influence of technology competition on bankruptcy. In this paper, we argue and find that the ongoing technology progress of firms contains important information with respect to the risk, costs, and pattern of bankruptcy.

As technology rapidly advances, firms have to operate in highly competitive environments full of gradual and radical innovations. These scenarios provide firms with an opportunity to become market leaders if they develop the most recent, updated, and well-adopted technologies. Yet, they also involve nontrivial operational risk if the firms lose in the technology race. That is, firms outperformed by their competitors in technology-intensive industries typically find it challenging to catch up, which could lead to a substantial bankruptcy risk. (1)

The patent system makes the relation between technology competition and bankruptcy even more direct. A patent assignee firm can sue competitors for infringement of its patents. Litigation may prohibit the defendant from performing any activities potentially related to that infringement. Should a court grant the plaintiff firm's request of injunction, some operations of the defendant could be shut down. This enforcement can result in severe financial distress for the defendant firm (see, e.g., Lanjouw and Lerner, 2001). Moreover, all other explicit and implicit costs arising in the patent litigation process can seriously deteriorate the financial status of the defendant (see Lerner, 1995; Hall, 2004).

We propose a simple model to analyze the association between technology competition and bankruptcy. The model considers two firms competing over a new technology in a representative industry and produces the effects of this competition on bankruptcy properties. The implications of the model are consistent with the economic intuition obtained from the literature and prompt three primary hypotheses. The first hypothesis posits that the level of a firm's technology competitiveness predicts its likelihood to go bankrupt. The common bankruptcy prediction models rely primarily on financial ratios that reflect the current financial status and operating performance of the firm. These ratios, however, do not necessarily capture the status of the firm in the technology competition, which can be a dominant factor in the survival of the firm, especially in industries characterized by intensive technological innovations.

The second hypothesis addresses the relation between bankruptcy and macroeconomic conditions. Economic intuition and the empirical evidence suggest that there are fewer bankruptcies in prosperous industries and when the economy is in good shape. We argue that this association is weaker for bankruptcies that are driven by technology competition. The intuition is as follows. Technological innovations typically enhance the economy, and particularly the technologyintensive industries (e.g., Hsu, 2009; Bena and Garlappi, 2011). Yet, at the same time, these innovations put the firms that lose in the innovation competition at a serious disadvantage, which could propel them toward bankruptcy (e. …

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