Are over-paid Chief Executive Officers better innovators?/
| Autor | Jouber, Habib |
| Cargo | Art |
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Introduction
The underling goal of tying managers' compensation to the firm's performance is the division of management and shareholder functions caused by the separation of control and ownership. CEOs performance-based compensation is therefore considered as the most powerful tool to reward both managers and shareholders. There are several reasons for this consideration. First, within the publicly traded corporations executive pay is a large debated issue. Second, pay-to-performance policies have significant outcomes (i.e, shareholders and managers interests' alignment, talent CEOs' retention, risk-taking encouragement, cash scarcity, accounting and tax treatment). Third, equity-based incentive instruments aim the long term firm's value maximization rather than the short-term earnings amplification. Compensation paid is a widely investigated area of research by both academic scholars and practitioners. Nevertheless, some CEOs incentives' outcomes are still inconclusive such as their intended purpose of enhancing managerial risk preferences and therefore firm innovation. Except of few studies (sheikh, 2012; Wu & Tu, 2007), little is known about the effects of incentive rewards on the CEO's risk-taking behavior. In this study, we aim to fill this gap. Our baseline hypothesis is the well-established argument by agency theorists that CEOs who receive stock option compensation are more likely to make riskier decisions since they participate in the upside potential of these decisions but not in their downside. This "paradigm" in considering the strategic expenses' implications of CEOs equity compensation is to investigate whether CEO is really motivated to incur R&D expenses. Our sensibility analyses go beyond this paradigm by examining if CEOs of high R&D intensive firms are really rewarded for the induced firm's profitability. We consider firm innovation characteristics (R&D expenditures, patents and citations to patents) to proxy for managerial strategic decision making.
Our paper contributes to previous research in the area in two aspects. First, in response to Wu & Tu (2007)'s call for additional research to investigate separately the impacts of share-based and stock option-based compensation on R&D expenses, we have demonstrated that stock options encourage investment in value-increasing innovations better than stock rewards. (1) second, this study is the first to highlight, both from a "statutory" and an "activist" perspective (Bebchuck, Cohen & Ferrell, 2009), whether CEOs' intends to invest in value-enhancing innovations are contingent upon compensation committee independence and investor protection level.
The rest of the paper proceeds as follow. The next section provides the literature review and develops the hypotheses. section 3 describes the data, variables and empirical methodology. Results, implications and robustness tests are reported in section 4. The last section concludes.
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Related literature and hypothesis development
2.1. Prior literature
Corporate governance theorists applaud the issue of CEOs performance-based compensation because they suggest that management incentive rewards yield immediate alignment of managers' interests with those of shareholders', which helps mitigate potential managerial opportunism and enhance firm value creation (Jensen & Meckling, 1976). Under this assumption, accounting and stock measures of performance are widely used in compensation contracts to interest the manager (agent) to maximize the owner's (principal) utility. (2) Shares and stock-options compensation plans can serve as a screening device to avoid adverse selection and moral hazard problems and hence, enhance firm value (Banker, Byzalov & Xian, 2011). Firm innovation is an important channel through which managers may increase firm value. Firm's innovation strategy can be characterized by different proxies such as patent counts (innovation magnitude), patent citations (innovation quality), technology class concentration, R&D expenditures, etc.
The empirical literature on the relationship between innovation and managerial incentives is limited. There is moreover, no consensus among researchers that performance-based incentives motivate managerial risk-taking and help to attract innovator agents.
On the one hand, by considering the behavioral agency approach, which draws upon agency and prospect theories, Wu and Tu (2007) and Bahaji (2011) have taken a contingent view toward pay-to-performance incentive effects. They report that, when rewarded for performance, managers become more risk-averse as a large lump of their personal wealth (financial and human capital) is directly dependent upon firm performance. Their models predict that managers may overestimate the values of their equity holdings in-excess of their risk-neutral value.
On the other hand, Cheng (2004) and Fernando and Xu (2012) dissert that CEOs may manage downward all possible expenses to provide a short-term boost to return at the expense of the firm's long-term profitability. Hence, CEOs' myopic behavior may occur when executives focus disproportionately on current earnings. However, using information on all patents granted in the US from 1976 to 2005, Sanyal and Luban (2010) find that innovation magnitude, quality and R&D quality have an inverted U-shape relationship with pay-performance sensitivity. Lerner and Wulf (2007) conclude that the log-term incentive compensation of corporate R&D managers is positively associated with patent citations, patent originality and patent awards. Aghion, Van Reenen & Zingales (2009) also find a strong link between CEOs (R&D managers) incentives and innovation (technology class concentration).
Banker et al. (2011) proceed differently. They examine the mediating effect of R&D intensity on the weights on signals of ability and financial performance measures in executive rewards. Their conclusions share with Cassiman and Veugelers (2006) in showing that, in optimal incentive contracts, proxies for managerial ability (work experience and relevant education) as well as the proportions of equity-based pay should increase with R&D intensity. Masli, Sanchez & Smith (2009) find that information technology (IT) expenses are associated with higher ratios of equity compensation. Their results are consistent with the notion that by tying CEO compensation to future outcomes, board of directors understand the uncertainty and risk profile of IT spending and place, consequently, greater weight on equity compensation. Xue (2007) studies whether the choice of performance measures used in executive compensation contracts can affect managers' choice between the in-house R&D and the licensing or external acquisition innovation strategies of obtaining new technology. (3) Using data from U.S. high-tech industries, they find that accounting-based cash compensation encourages managers to pursue the "buy" strategy instead of the "make" strategy, while stock-based pay encourages managers to adopt the "make" strategy. Onishi (2012) reports that the introduction of a revenue-based compensation plan for employee inventions that is linked to the patent's contribution to the firm's sales, profit, or license royalties significantly lead to an increase in the number of highly cited patents while these compensation plans do not lead to an increase in the number of Japanese and U.S. patents. Based on arguments from labor market and social comparison researches, Fong (2010) examines whether CEO underpayment relative to the labor market affects R&D spending. He suggest that relative CEO underpayment is associated with reductions in R&D spending in low R&D intensive industries and increases in R&D spending in high R&D intensive industries. Erkens (2011) find a positive interactive effect of secrecy on executives' unvested equity holdings and R&D-intensity. Moreover, he concludes that the interactive effect is more pronounced for executives who are more likely to have the required skills and knowledge to exploit information about R&D investments. Using a sample of firms from the knowledge-intensive biotechnology industry, Levitas, Barker III & Ahsan (2011) have found a positive relationship between R&D spending and managerial incentive plans.
Consistent with these empirical researches, we state our first hypothesis as follows:
HI: A firm's innovation intensity and quality is positively associated with the EDOL.
2.2. Moderator effects of contextual features
Empirical literature on the relation between incentives and innovation generally omit the mediating effects of some contextual and specific features on such relation. Board oversight effectiveness and investors' rights protection level were, for example, considered by numerous studies as strong determinants of both firm's compensation and innovation strategies.
On the one hand, Liu (2008) reports evidence that remuneration committee of R&D intensive firms reduce the use of accounting relative performance evaluation rewards to prevent the management's myopic behavior patterns. Hermanson, Tompkins, Veliyath & Ye (2012) finds that the interaction between the percentage of outside directors on boards and the level of their stock-option compensation is positively related to firms' R&D intensity. Henry et al. (2011) dissert that maintaining an effective internal control system imposes greater costs on (and requires higher levels of effort from) the manager and the firm must therefore grant higher levels of executive compensation to properly incentivize effort-averse managers. They conclude that the explained (unexplained) component of compensation is positively (not) related to the probability of effective internal control. Morse, Nanda & Seru (2011) argue that, when a board is relatively weak, powerful CEOs get paid more. Firth, Fung & Rui (2007) support the prediction that CEOs facing less monitoring form firm owner may be encouraged to behave opportunistically towards R&D...
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