Inside directors and the underinvestment of financial slack towards R&D-intensity in high-technology firms

Abstract

Agency theory emphasizes the role of outside directors in mitigating free cash flow (FCF) problems, such as overinvesting FCF's into negative NPV R&D projects. In this paper we draw on and extend agency theory to argue that the underinvestment of financial slack towards a persistently high R&D-intensity is actually a greater problem for high-tech firms. Specifically, we claim that inside directors play a critical role for the board in safeguarding R&D investment by monitoring the CEO, and mitigating informational asymmetries for independent directors. We test our theory using a panel-data set of S&P 1500 firms in R&D-intensive industries from 1997 to 2007. Our empirical analysis reveals that inside directors positively influence the relationship between financial slack and R&D-intensity, and that their ability to ensure cash holdings are used to preserve R&D matters the most during periods of financial distress.