Motivating high‐impact innovation: Evidence from managerial compensation contracts

• Date: 01 August 2019
• Published date: 01 August 2019
• Author: Bill B. Francis,Zenu Sharma,Iftekhar Hasan,Maya Waisman
• DOI: http://doi.org/10.1111/fmii.12115

DOI: 10.1111/fmii.12115

ORIGINAL ARTICLE

Motivating high-impact innovation: Evidence from

managerial compensation contracts

Bill B. Francis1Iftekhar Hasan2Zenu Sharma1MayaWaisman3

1Lally School of Management, Rensselaer

Polytechnic Institute, 110 8th Street, Pittsburgh

Building, Troy,NY 12180–3590

2FordhamUniversity, Bank of Finland and

University of Sydney,45 Columbus Avenue, New

York,NY 10023

3FordhamUniversity, 45 Columbus Circle, New

York,NY 10023

Correspondence

ZenuSharma, Lally School of Management,

RensselaerPolytechnic Institute, 110 8th Street,

PittsburghBuilding, Troy,NY 12180–3590, USA.

Email:sharmz2@rpi.edu

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. Testsusing 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.

KEYWORDS

CEO compensation, innovation and incentives

JEL CLASSIFICATION

D8, O31

1INTRODUCTION

As competition intensifies and the pace of change accelerates, firms need to renew themselves by innovating and

exploringnew competencies. Innovation, however, is a high-risk activity that requires long-term commitment of corpo-

rateresources and managerial talent (Aghion & Tirole, 1994; Holmstrom, 1989). As such, a risk-averse manager, whose

c

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Financial Markets,Inst. & Inst. 2019;28:291–318. wileyonlinelibrary.com/journal/fmii 291

292 FRANCIS ET AL.

payis tied to firm performance, may choose to forgo risky, albeit positive NPV innovation, to the detriment of the firm’s

long-term survival, and invest in lower risk projects that are more likelyto assure rewards and job security in the short

run (Ederer & Manso, 2013; Hirshleifer & Thakor,1992; Manso, 2011).

Several papers (e.g.,Holmstrom, 1989; Manso, 2011) develop theoretical models that address the question of how

to motivate managers to innovate. These papers suggest that to induce managers to undertake innovation which is

characterized by long gestation periods and high rates of failure, shareholders should provide CEOs with contracts

that include option grants and golden parachutes. These contract features will not only provide managers with long-

term commitment, but will also incentivize their risk-taking, and protection from, or even reward for short term fail-

ure and its resulting job loss (Hall & Murphy, 2003; Kole, 1997; Laux, 2012). However, although academics have long

noticed the importance of providing the right incentives for innovation(e.g., Manso, 2011; Smith & Stultz, 1985; Smith

& Watts,1992, among others), surprisingly, most of the relevant research is theoretical or experimental in nature (see,

e.g., Azoulay,Graff Zivin, & Manso, 2011; Ederer & Manso, 2013, among others).

In addition, the existing empiricalwork has focused on the correlation between CEO compensation and investment

in innovation, in general, while ignoring the question of how to motivate managers to undertake breakthrough, high-

impact innovative projects. We know that firms can invest in exploratoryprojects, where they can pursue new knowl-

edgeand develop new products and services for emerging customers and markets, and/or in exploitativeprojects, where

theybuild upon existing knowledge, products and services for existing customers (Benner & Tushman, 2003). While the

importance of pursuing both types of innovation has often been highlighted in research on organizational learning and

strategy (Lee, Lee, & Lee, 2003; Levinthal & March, 1993), innovation(Danneels, 2002; Rothaermel & Deeds, 2004),

and entrepreneurship (Shane & Venkataraman,2000), much more remains to be understood about how organizations

can motivate managers to undertake risky,high-impact innovation.

In this paper, combining data on innovation with comprehensive information on CEO compensation for the

years 1992–2009, we document a significant, positive relationship between managerial compensation contracts that

encourage long-term commitment in the form of new option grants and previously granted vested and unvested

options and innovation input (R&D expenditures) and output (the number of patents and citations).1In contrast, we

find that short-term, cash based incentives havea detrimental effect on firm innovation.

We also find that the existence of golden parachutes that make it very costly for firms to terminate managers,

thereby protecting them from project failure, are associated with a positiveand significant effect on corporate innova-

tion. This is consistent with the argument that managerial job security can elicit more tolerancefor early project failure

and can therefore, encourage managers to makemore novel, risky investment decisions (Azoulay et al., 2011; Ederer &

Manso, 2013; Holmstrom, 1989; Manso, 2011).

We then turn to examining the effect of managerial compensation on the innovative strategy of a firm. Using the

innovation breakthrough measures introduced by Balsmeier, Fleming and Manso (2016), we find that option and

golden parachute compensation havea stronger positive effect on risky, explorative projects than they do on exploita-

tiveinnovation. This is consistent with the intuition that option grants and golden parachutes can incentivize risk taking

and investment in breakthrough inventionthat is associated with higher rates of failure.

To establish causality between managerial compensation and firm innovation,we follow the methodology imple-

mented by Hayes, Lemmonand Qiu (2012), who used the accounting regulation, FAS 123R that took effect in 2005 as

an exogenous shock to managerial option compensation. While, prior to the implementation of FAS123R, firms were

allowed to expense stock options at their intrinsic value, and thus were able to grant stock options at-the-money,with

no expenses for option-based compensation on the income statement, the implementation of FAS 123R eliminated

firms’ ability to expense options at intrinsic value and required them to expenseall stock based compensation at their

fair value. Such a change removed the accounting advantages associated with option grants relative to restricted

stock grants, and resulted in a significant reduction in stock options granted to employees (see, e.g., Carter, Lynch,

& Tuna, 2007, among others).2Following Hayes et al. (2012), among others, we employ a difference-in-differences

approach that compares the change in innovation of firms that were affected by FAS 123R (i.e., treatment firms) to

that of firms that were not affected by the accounting regulation (i.e., control firms). Using the passage of FAS 123R