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

Abstract

When customers face financing frictions, they are incentivized to retain suppliers through nonmonetary incentives, such as by sharing technology with suppliers, thereby fostering supplier innovation. Using customer-supplier pairs in the U.S., we find that suppliers of customers that violate covenants become more innovative, specialize in narrow areas, and exhibit greater tendencies to cite and coordinate with customer innovation. Additionally, supplier innovation increases more when suppliers have greater financing flexibility, customers are highly specialized and stakeholder-friendly, and both trading partners are more trustworthy. Such innovation positively influences customer relationships, supplier performance, and supplier-firm survival. Overall, our findings illustrate nonmonetary channels that motivate relationship-specific investments.

Keywords: Innovation, Customer-Supplier Relationship, Debt Covenant Violations, Firm Performance

JEL Classification: O30, L14, L24, G32, G33