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.
This study uses systems of simultaneous equations to model the interdependence between compensation incentives and measures of firm innovation.
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.
Measuring innovation output is difficult as innovation could take different forms, including business model innovation, which does not appear in the patent data.
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.
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).
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