Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation

Abstract

A firm's board of directors, based on its risk tolerance or ''appetite,'' sets the corporate objectives. It is then the management's job to meet the objectives by adopting appropriate strategies. However, the board can design compensation policies to encourage desired management strategy choices. This paper explores the extent to which management compensation policies are aligned with strategy choices for obtaining new technology. Firms obtain new technology either through internal R&D or through acquisitions, often labeled ''make'' and ''buy'' strategies, respectively. The ''make'' strategy is inherently more risky, with much of the high risk idiosyncratic. Furthermore, U.S. GAAP requires that R&D expenditures be expensed but allows capitalization of acquisition costs, thus a firm using the ''make'' as opposed to the ''buy'' strategy will experience a greater negative effect on accounting earnings. I hypothesize that these differences will lead risk-averse and utility-maximizing managers to implement the ''buy'' strategy if their compensation is heavily weighted on accounting-based performance measures. Conversely, managers with more stock-based compensation, especially stock options, are more likely to choose to develop new technology internally. Using data from U.S. high-tech industries and a simultaneous equations regression framework, I find evidence consistent with the above hypotheses.

What Explains the Valuation Difference between Intangible‐intensive Profit and Loss Firms?

“…In this section, we try to account for the endogenous nature of the choice between R&D and recognized intangibles . Following Xue (), we use MTB , LEV , CASH , SIZE , IND , INDRDAS and INDINTANS as variables that affect the choice between internal development and external purchase of intangibles . Xue also includes compensation‐related and other variables, but we do not include them because the data for executive compensation are available only after 1992 and only for a subset of firms.…”

“…We only include in this estimation the firm–year observations with positive values of RDAS and INTANS . Consistent with Xue (), we use INDRDAS and INDINTANS as instrumental variables and RDAS and INTANS as endogenous variables. We then rank the predicted values of RDAS and INTANS into quintiles and generate PRDAS and PINTANS , respectively.…”

“…In this section, we try to account for the endogenous nature of the choice between R&D and recognized intangibles. 20 Following Xue (2007), we use MTB, LEV, CASH, SIZE, IND, INDRDAS and INDINTANS as variables that affect the choice between internal development and external purchase of intangibles. 21 Xue 19 The principal component explains 87% of the variation in the three control variables, STKISS, LgSTKISS and CASH.…”

Attributes of social and human capital disclosure and information asymmetry between managers and investors

“…In our case, we used the independent variables in equations 1 (b, c, and d) as instruments to obtain the fi tted values of our three disclosure variables and then substituted the fi tted values into equation 1(a) in lieu of the disclosure variables. Use of the lagged form of the explanatory variables for the disclosure regressions mitigated concerns about endogeneity and made these variables appropriate to use as instruments (see Xue, 2007;Pyndick & Rubinfeld, 1991 for further details). In the third and fi nal stage, the 2SLS residuals were used to estimate the cross-equation error covariance matrix and to generate correlation coeffi cients, which was more effi cient than 2SLS.…”

Executive stock options and firm valuation: a literature review and research framework

“…It is also believed that board of directors prefer to use executive stock options instead of cash compensation to reduce the costs of monitoring executive activities, as this long-term incentive plan imposes compensation risks 9 (which increase in the use of stock options) on the executive. In fact, Xue (2007) provides evidence that a firm's board of directors use stock options to "...pursue innovation through internal R&D". In fact, Xue (2007) provides evidence that a firm's board of directors use stock options to "...pursue innovation through internal R&D".…”