Do Ceo Compensation Incentives Affect firm Innovation?

The current issue and full text archive of this journal is available at www.emeraldinsight.com/1475-7702.htm

RAF 11,1

Do CEO compensation incentives affect firm innovation?
Shahbaz Sheikh
University of Western Ontario, London, Canada
Abstract
Purpose – The purpose of this paper is to examine if the structure and design of CEO compensation has any effect on firm innovation. It further investigates the effectiveness of each component of portfolio of compensation incentives in encouraging innovation. Design/methodology/approach – This study uses systems of simultaneous equations to model the interdependence between compensation incentives and measures of firm innovation. Findings – Results indicate that the pay-performance sensitivity of the CEO portfolio of compensation incentives is positively related to investment in R&D expenditures, number of patents and citations. Options in general are more effective than stocks. However, within the options portfolio, recently awarded and unvested options are more effective than previously awarded and vested options. Restricted stock is more effective than unrestricted stock. Research limitations/implications – Measuring innovation output is difficult as innovation could take different forms, including business model innovation, which does not appear in the patent data. Practical implications – Stock options encourage investment in value-increasing innovations and should remain a significant part of managerial compensation. If the firm awards stock, it should only award restricted stock. Originality/value – This study uses comprehensive measures of compensation incentives and firm innovation. It views incentives as a portfolio of stock and options and uses incentives in their entirety. It examines the effectiveness of each component of the portfolio in encouraging innovation. It measures innovation as investment into the innovation process (R&D expenditures) and the resulting success of that investment (patents and

Citations: CEO stock ownership Founding family CEO age Horizon CEO tenure Outsider Cash compensation Total compensation R&D R&D capital stock R&D missing Three-year stock returns Firm size Debt-to-assets Market-to-book Operating cash Table AI. Firm risk Market Description Number of patents filed by a firm in a year/mean number of patents by all firms in the same year and technology class Number of citations received by all patents of a firm in a year/ mean number of citations received by all firms in the same year and technology class CEO stock holdings as a percentage to total shares outstanding Indicator variable equals 1 if CEO is founder or belongs to a founding family and 0 otherwise Age of the CEO in years Indicator variable equals 1 if CEO is more than 60 years of age Number of years the CEO has been in office Indicator variable equal 1 if the CEO was hired from outside the company and 0 otherwise Salary plus bonus Salary, bonus, other annual, total value of restricted stock granted, total value of stock options granted, long-term incentives payouts and all other total Research and development expenditures/book value of assets: missing values replaced with zero R&Dt þ 0.85 R&Dt2 1 starting with the year 1976 since the innovation data are available since 1976. This formula, following Hall (1990) assumes a 15 percent depreciation rate Indicator variable equals 1 if R&D is missing and 0 otherwise Three-year total return to shareholders including the monthly reinvestment of dividends Log of sales Long-term debt/book value of assets (book value of assets – book value of common equity þ market value of equity) book value of assets Cash from operating activities – common dividends – preferred dividends/book value of assets Annualized stock return volatility calculated over 60 months Indicator variable equals 1 if year . 1999 and 0 otherwise About the author Shahbaz Sheikh is Associate Professor of Finance at the Dan Program in Management and Organizational Studies, the University of Western Ontario. He earned his MS and PhD degrees from the International Business School, Brandeis University. His research interests are in the areas of corporate finance and corporate governance. He has published in Journal of Corporate Finance, the Financial Review, Journal of Economics and Business, Quarterly Journal of Finance and Accounting, International Finance Review, The International Journal of Finance and Journal of Systems and Software. Shahbaz Sheikh can be contacted at: [e-mail] CEO compensation incentives 39 To purchase reprints of this article please e-mail: [e-mail] Or visit our web site for further details: www.emeraldinsight.com/reprints