Reasons for Financing R&D Using the SWORD Structure

Several companies in the science and technology-based industries used the SWORD structure to finance some of their R&D programs. Yet, there is no clear rationale or evidence that this structure is improves welfare. This study explores and/or develops 5 testable hypotheses pertaining to the reason(s) some firms use the SWORD structure. The five hypotheses are (1) Earnings management hypothesis; (2) Debt overhang/insurance hypothesis; (3) Separation of assets of different risk classes hypothesis; (4) Information asymmetries hypothesis; and (5) Sequential investment problem hypothesis. The final sample consists of 41 companies making 66 SWORD announcements. Companies that form SWORD structures are young, high growth and small capitalization companies that operate mainly in science and technology based industries. They have the same leverage ratios as the average company in their industry. They are financially healthy, and they form SWORD structures after periods of strong stock performance. The strong impact SWORD structures have on the parent company’s financial statements support the earnings management hypothesis. The average leverage ratios of the sample companies fail to support the debt overhang/debt insurance problems. Consistent with the implicit assumption of increased survivability in the separation of different risk classes hypothesis we find that the formation of the first SWORD structure increases the probability of survival for the parent company, in the 5 years following the SWORD formation, by 23 percent. SWORD structures do not reduce information asymmetries for the parent company. The form of payment for the acquisition and the moneyness of the warrants at the acquisition and expiration times provide support for the sequential investment problem hypothesis. Overall the results indicate that although SWORD structures can be used to make financial statements look better, they can also provide solutions to the unique problems of R&D investment. Based on the findings further regulation but not elimination of the SWORD structures is recommended.