Do Cash-Flow Performance Metrics in CEOs’ Compensation Contracts Enhance Firm Innovation?

Abstract

Building on prior research showing a positive link between internally generated cash flows and innovation output, we hypothesize and find that the inclusion of cash-flow performance metrics in CEOs’ compensation contracts positively impacts firm innovation. Our findings are consistent with the theory that cash-flow metrics incentivize CEOs to make prudent investment decisions, thereby addressing both the overinvestment and the underinvestment challenges for firm innovation. As a result, firms utilizing cash-flow metrics exhibit lower innovation input and higher innovation output compared to firms not employing such metrics. Furthermore, our research indicates that the incentive effect of cash-flow metrics on firm innovation is more pronounced when cash flows convey unique information not reflected in earnings and when CEOs have longer expected employment horizons. This study underscores the effectiveness of cash-flow metrics in motivating management to promote firm innovation. Data Availability: Subscription-based data are obtained from Wharton Research Data Services; public data are obtained from public sources specified in the paper. JEL Classifications: D81, G30, J33, M52.