Motivating high‐impact innovation: Evidence from managerial compensation contracts

Abstract

We investigate the relationship between Chief Executive Officer (CEO) compensation and firm innovation and find that long‐term incentives in the form of options, especially unvested options, and protection from managerial termination in the form of golden parachutes are positively related to corporate innovation, and particularly to high‐impact, exploratory (new knowledge creation) invention. Conversely, non‐equity pay has a detrimental effect on the input, output and impact of innovation. Tests using the passage of an option expensing regulation (FAS 123R) as an exogenous shock to option compensation suggest a causal interpretation for the link between long‐term pay incentives, patents and citations. Furthermore, we find that the decline in option pay following the implementation of FAS 123R has led to a significant reduction in exploratory innovation and therefore had a detrimental effect on innovation output. Overall, our findings support the idea that compensation contracts that protect from early project failure and incentivize long‐term commitment are more suitable for inducing high‐impact corporate innovation.

CEO pay sensitivities in innovative firms

“…Positive momentums in R&D innovations that extend from previous successes through CEOs' change seem unaffected by CEO compensation (Tien and Chen, 2012). However, contrary to this, when considering non-equity pay, studies find that it has a detrimental effect on innovation (Francis et al , 2019). Even though compensations protect the CEOs from projects' failures in their early stages and incentivizes more long-term commitments like unvested options, together with golden parachutes, such compensations induce corporate innovation (Francis et al , 2019).…”

“…However, firms use multiple performance measures in contracts with CEOs. Among these, the percentage of stock return is a price–performance measure, which can reduce CEOs' risk-taking behavior to shield the CEOs from value-enhancing project selections (Duru et al , 2002) and early failures (Francis et al , 2019).…”

Exploration or exploitation? A study on equity incentive design, dynamic decision making, and economic consequences

“…However, prior studies have not reached a consensus on whether vesting periods can induce innovation. Some researchers believe that long-term compensation contracts, combined with golden parachutes and other interest-related protection measures for top executives, are more effective in stimulating R&D expenditure and innovation output [ 13 , 14 ]. In contrast, others find that implementing long-term incentives is a double-edged sword [ 24 , 29 ].…”

“…Prior studies have found that equity incentive have a positive effect on corporate innovation [ 4 , 12 ]. And incentive schemes with long vesting periods lead to better innovation performance [ 13 , 14 ]. Current literature usually uses R&D investment and patent output to measure innovation, but these measures have significant limitations in measuring innovation [ 15 – 17 ].…”

Fostering innovation: Experimental evidence on the effectiveness of behavioral interventions

“…Similarly, funding policies that tolerate early failure and reward long-term success motivate innovation in scientific research [ 29 ]. A positive relationship between innovation and compensation schemes which protect managers from termination is also documented [ 30 ]. Also, innovation is documented to be greater when the bankruptcy code is debtor-friendly [ 31 ].…”