Make or Buy New Technology - A CEO Compensation Contract's Role in a Firm's Route to Innovation

Abstract

Firms obtain new technology either through internal R&D or through acquisitions. These two approaches are usually labeled as “make” and “buy” strategies. In this paper, I examine the relation between a firm’s choice of “make” or “buy” and the performance measures used in the firm’s CEO compensation contract. I focus on the two major differences between “make” and “buy” strategies: the risk levels and accounting treatments. I then examine the differential implications of accounting-based and stock-based performance measures on managers’ incentive in choosing between the two strategies. Using data from US high tech industries, I find that, firms relying on “buy” approach to obtain technology tend to depend more on the accounting-based performance measures, while those firms who innovate through R&D activities skew toward stock-based pay especially stock options.