Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation

Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation A firm’s board of directors, based on its risk tolerance or “appetite,” sets the corporate objectives. It is then the management’s job to meet the objectives by adopting appropriate strategies. However, the board can design compensation policies to encourage desired management strategy choices. This paper explores the extent to which management compensation policies are aligned with strategy choices for obtaining new technology. Firms obtain new technology either through internal R&D or through acquisitions, often labeled “make” and “buy” strategies, respectively. The “make” strategy is inherently more risky, with much of the high risk idiosyncratic. Furthermore, U.S. GAAP requires that R&D expenditures be expensed but allows capitalization of acquisition costs, thus a firm using the “make” as opposed to the “buy” strategy will experience a greater negative effect on accounting earnings. I hypothesize that these differences will lead risk-averse and utility-maximizing managers to implement the “buy” strategy if their compensation is heavily weighted on accounting-based performance measures. Conversely, managers with more stock-based compensation, especially stock options, are more likely to choose to develop new technology internally. Using data from U.S. high-tech industries and a simultaneous equations regression framework, I find evidence consistent with the above hypotheses. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Accounting Studies Springer Journals

Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation

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Publisher
Springer US
Copyright
Copyright © 2007 by Springer Science+Business Media, LLC
Subject
Business and Management; Accounting/Auditing; Corporate Finance; Public Finance
ISSN
1380-6653
eISSN
1573-7136
D.O.I.
10.1007/s11142-007-9039-y
Publisher site
See Article on Publisher Site

Abstract

A firm’s board of directors, based on its risk tolerance or “appetite,” sets the corporate objectives. It is then the management’s job to meet the objectives by adopting appropriate strategies. However, the board can design compensation policies to encourage desired management strategy choices. This paper explores the extent to which management compensation policies are aligned with strategy choices for obtaining new technology. Firms obtain new technology either through internal R&D or through acquisitions, often labeled “make” and “buy” strategies, respectively. The “make” strategy is inherently more risky, with much of the high risk idiosyncratic. Furthermore, U.S. GAAP requires that R&D expenditures be expensed but allows capitalization of acquisition costs, thus a firm using the “make” as opposed to the “buy” strategy will experience a greater negative effect on accounting earnings. I hypothesize that these differences will lead risk-averse and utility-maximizing managers to implement the “buy” strategy if their compensation is heavily weighted on accounting-based performance measures. Conversely, managers with more stock-based compensation, especially stock options, are more likely to choose to develop new technology internally. Using data from U.S. high-tech industries and a simultaneous equations regression framework, I find evidence consistent with the above hypotheses.

Journal

Review of Accounting StudiesSpringer Journals

Published: May 12, 2007

References

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