The Interactions between R&D Investment Decisions and Compensation Policy

Abstract

We use a system ofequations to investigate the endogenous relation between R&D investment and CEO compensation. Growth opportunity is positively related to the use ofstock options. Stock options positively affect R&D while restricted stock has a negative influence. These results suggest that CEO compensation should balance incentive alignment and efficient risk sharing with risk-averse managers. Stock options are also found to be negatively related to leverage, but positively related to convertible debt. Additionally, this analysis suggests that institutional ownership directly influences R&D investment by providing managerial oversight and indirectly by influencing the compensation policy. The study examines the interaction between R&D investment decisions and corporate compensation policy in 1,088 firms for fiscal year 1997. Two different two-stage limited dependent variable models in which equity-based awards and R&D investment are both endogenous are used. In the first model, we do not distinguish between the types of equity-based compensation (options or restricted stock). In the second model, we treat the type of stock compensation as an endogenous choice. Previous research recognizes the endogenous relation between investment opportunity and compensation policy, but models the determinants of these decisions separately. There are two benefits from estimating these relations as a system of equations. First, if the true relation is endogenous, single equation ordinary least squares will produce estimates that are inconsistent (Kmenta, 1986). Second, estimating these relations in a system allows us to draw inferences regarding causality in these relations. Specifically, it offers insight into the influence of compensation on R&D investment as well as the influence of investment opportunity on compensation policy. We note the following determinants of R&D investment. When we treat all stock-based incentives equally, R&D is positively related to equity-based compensation. When we separate the types of equity compensation into options or restricted stock, options exert a positive influence on R&D and restricted stock exerts a negative influence. These findings support the hypothesis that the linear payoff of restricted stock encourages managers to avoid risky investment and the nonlinear payoff of options motivates risk-taking behavior. The relation between age and R&D investment is concave, confirming the premise that both the very youngest CEOs, who seek short-term results to build their reputations and the very oldest CEOs, who have limited horizons due to their impending retirement have the incentives to invest less in uncertain long-term projects. We also observe a negative relation with poor financial solvency.