Bottom Line: Innovation is often the way for newly public companies to differentiate themselves from the competition. If shareholders want to motivate their CEOs to pursue visionary innovation objectives, they should encourage a strategy of both short-term job security and the cultivation of a long-term outlook.
It’s a classic conundrum for shareholders: How do you convince managers to pursue lasting initiatives that benefit the firm in the long run, rather than more superficial strategies that seem likelier to pay off right away? After all, executives have a natural incentive to focus on immediate success because it reflects well on them and can trigger lucrative performance bonuses. But shareholders typically prefer that managers focus on more complex projects that will bear fruit further in the future. Although these initiatives are riskier and may not even show results until long after the departure of the executives who initiated them, they generate the long-term, sustainable value so prized by shareholders and envied by competitors.
However, some scholars have warned that a firm’s focus on future goals can have the unfortunate side effect of dragging down its current performance , and may require shareholders to develop an acceptance of failure in the short term to give managers more incentive to tinker with and improve long-term innovation projects. Indeed, many executives put anti-takeover provisions in their contracts, measures designed to strengthen their job security in the short term by discouraging bids from rival firms. But in effect, this entrenchment results in rewarding managers even if their performance record is poor.
A firm’s focus on future goals can have the side effect of dragging down its current performance.
One possible solution is for firms to compensate their CEO with stock options that vest quickly—thereby giving the chief executive a slice of ownership in the company. And the value of that stock, over time, will be determined by the company’s future performance, giving the CEO a solid incentive to lay the groundwork for successful long-term endeavors.
To explore how companies’ use of deferred compensation, different vesting time frames, and anti-takeover mechanisms colors CEOs’ efforts to obtain patents, the authors of a new paper analyzed a sample of 360 U.S. firms that went public during a recent four-year period. And in the first study to test whether these strategies can be complementary, the authors found that the right combination of compensation plans and job protection can provide a powerful incentive for a company’s leaders to seek out and secure patents.
The authors focused on newly public firms because most are naturally geared toward innovation. In addition, an IPO offers an ideal opportunity to explore the link between the intensity of a company’s patent activity and its corporate governance structure, aspects of a firm’s charter that are often reviewed and revised during the IPO stage.
Combining several databases, the authors first analyzed the information contained in each firm’s prospectus before it went public, including bylaws, governance, and the CEO’s compensation plan. They also used patent data to determine the level of a company’s innovation, computing the number of patents the firm applied for in advance of going public, how many it applied for during the two years after the IPO, and the number of patents that were actually granted.
To determine whether CEOs’ individual abilities could affect their firm’s innovation activities, the authors compiled information on the executives’ previous leadership experience, their level of education, and the type of degree they had earned. Interestingly, the only factor that caused any noticeable uptick in innovation effort was having an especially technical background—in engineering, medicine, or natural sciences, for example.
The average CEO in the study earned about two-thirds of his or her compensation through the mechanism of deferred stock options. The maximum vesting period for CEOs’ unexpired options at the time of the IPO date—or the time that must have elapsed before the executives could cash in on their company stock—varied from six months to 15 years; the average was slightly lower than 4.5 years.
Several findings emerged. Most importantly, the authors found that the average firm pursuing an intense innovation strategy gave its CEO a larger chunk of compensation in incentives, which came with longer vesting periods. However, such firms also afforded their chief executive much more stringent protection from takeovers or early termination. It appears that the combination of short-term job security and an incentive-based compensation scheme that stresses a long-term outlook is the best way of motivating a CEO to concentrate on innovation.
On the flip side, companies that displayed a decided indifference toward innovation after going public gave their CEO more compensation in salary, shorter vesting time frames, and less job security.
Of course, not every firm filing for an IPO wants to get involved in patents. But the authors found that these relationships between a CEO’s contract and a firm’s innovation held even when they excluded companies in industries with relatively little patent activity.
In recent years, promoting innovation has become a critical part of the competition between companies and even countries, the authors note. And there’s no doubt investors are paying attention: The authors found that the anticipated innovation efforts of firms going public were a significant factor in their IPO valuation when they eventually did hit the stock market.
Source: Motivating Innovation in Newly Public Firms, by Nina Baranchuk (University of Texas at Dallas), Robert Kieschnick (University of Texas at Dallas), and Rabih Moussawi (University of Pennsylvania), Journal of Financial Economics, Mar. 2014, vol. 111, no. 3