Innovation, R&D and Managerial Compensation

This paper investigates whether aligning manager and owner incentives can improve the innovation performance of firms. We find that as managerial wealth becomes more sensitive to the firm’s stock price (increasing pay-performance sensitivity); the innovation performance of a firm improves. Specifically, we find that the magnitude and quality of innovation, R&D expenditure and technology concentration all have a non-monotonic relationship with pay-performance sensitivity. Each of these metrics of innovation first increase with pay-performance sensitivity, and then decrease at very high levels of pay-performance sensitivity. However, the quadratic term is economically insignificant in all cases and the overall impact is a positive relationship between performance pay and innovation. We also find that as managers get more invested in the firm they may be unwilling to take greater risk that may jeopardize their wealth, as shown by a negative effect of increased managerial stock holdings on innovation magnitudes and R&D investment. Additionally, short-term incentives, as measured by the annual bonus to salary ratio, do not influence the innovation performance of the firm. Interestingly, managerial tenure has a positive impact on R&D expenditures, suggesting that as managers stay in the same firm for a longer period of time, some of their career concerns may be mitigated and they are more willing to take on potentially value enhancing risky investments such as R&D