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Since Joseph Schumpeter, economists have argued that internal finance should be an important determinant of R&D expenditures. Yet almost without exception, previous empirical studies have not found evidence of such a relation. Using newly available data, the authors investigate this puzzle with a panel of 179 small firms in high-tech industries. Under each estimation strategy they employ, the authors find an economically large and statistically significant relationship between R&D investment and internal finance. Their results are consistent with the view that, because of capital market imperfections, the flow of internal finance is the principal determinant of the rate at which small, high-tech firms acquire technology through R&D. Copyright 1994 by MIT Press.