This study scrutinizes the association between a bank loan to a financially distressed firm and technological innovation. Using probit model estimations based on a comprehensive Korean manufacturing firm‐level data set on innovation and bank loans, we first find that a bank loan to a troubled firm with a weak incentive system has no or little effect on innovation. Second, beneficial effects on innovation are observed when the firm has a strong incentive‐based pay system. Third, financially distressed firms with strong incentive systems pursue product innovation rather than process innovation. Finally, the innovation performance of these firms strengthens with more stable financing.