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

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

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