The influence of Outside Directors’ Stock-Option Compensation on Firms’ R&D

The examination of the effects of outside director's stock-option compensation on

firm's R&D intensity.

Two views

• The institutional investor • Daily

The institutional investor community

• Has been an active proponent of including stock-based compensation as a complementary measure to increasing the representation of outside directors on corporate boards.

Daily

• Warns that corporations should be cautious in adopting this practice at least until there is evidence that this compensation scheme will in fact benefit stockholders. To date, this is not really known.

Filling the gap

• This paper attempts to fill this gap by examining the relationship between the level of stock option components in outside director's pay and firms' R&D expenditures.

• Rationale: a firm's R&D expenditure analysis provides an indication of board effectiveness as it represents a strategic decision in which managers and shareholders have conflicting interest.

The Conflict

• R&D involves a temporal trade-off between short term financial performance for long term performance gains.

• R&D also increases a firm's risk due to the high probability of failure

The conflict• Management and Shareholders have conflicting interest

regarding R&D expenditures due to their difference in temporal preferences and their attitude towards risk

• Management: – are more preoccupied with safety, leading them to under invest in

long-term, risky projects. – less likely inclined to invest in long term projects as these will likely

only be manifested after they have left the firm and hence not have the same positive impact on their careers that short term increases in financial performance may have.

• Shareholders: – favour investment in R&D because they can diversify inherent R&D risk

The potential solution

• A firm's board is considered an important mechanism for limiting manager's self-serving behaviour as it can protect the interest of shareholders by ensuring the formulation of effective strategies

External Directors: Stock Based Compensation

• All research in area based on agency theory– “Agent is self-serving individual who are effort and

risk averse”– Firms must implement mechanisms that align the

goal of the Agent and the Shareholder• Stock based compensation is widely accepted

method of aligning goals

External Directors: Stock Based Compensation

• Equity Based Compensation: – Aligns Director Risk/Effort aversion levels with

Shareholders – ALIGNS GOALS• By aligning goal with SH, Directors will more closely

monitor CEO• Proofs:– Perry: “CEO more likely to be removed after failed

performance when BOD is receiving incentive pay”– Ryan: “CEO’s use power to REDUCE the BOD’s incentive

pay” thus protecting themselves

Payment Structure: Stock vs. Stock Options

• Stock Payment– Ties agent and SH wealth EQUALLY to each other– When one rises/falls, so will the other

• Stock Options– Ties agent wealth to shareholder’s MORE closely

when firm value INCREASES– But, LESS less closely when firm value drops– Therefore, more accepting of risk, which SH like

Hypothesis #1

THE HIGHER THE OUTSIDE DIRECTORS STOCK-OPTION COMPENSATION, THE HIGHER THE

FIRMS R&D INTENSITY WILL BE.

Board Compensation

• Many researchers agree that the more external directors, the more effective the managerial monitoring will be

• Insiders more likely to align themselves with CEO

• Studies show that when no incentive pay is used, the proportion of Insiders does not = effective monitoring

Hypothesis #2

THE INTERACTION BTW THE PERCENTAGE OF OUTSIDE DIRECTORS ON BOARDS AND THE

LEVEL OF THEIR STOCK OPTION COMPENSATION IS POSITIVELY RELATED TO

FIRMS R&D INTENSITY.

Research Methods Used

• Sample– Combined data from three archival data sources• Standard and Poor’s ExecuComp database• Standard and Poor’s Research Insight • Investor Responsibility Research Center, Corporate

Governance Service – S&P 1500 firms between 1997 – 2000– Sample size: 1,188 firm-years

Research Methods Used

• Variables – Dependent Variable = R&D Intensity• Firm’s reported annual R&D expenditure per employee

– Independent Variable = Stock-Option Compensation• Value of stock options granted to an outside director

during a firm’s fiscal year– Control Variables• Included in the model to account for other factors that

might affect R&D intensity

Control Variables• Performance – Return on Equity• Firm leverage – Ratio of Debt to Equity• Firms’ liquidity – Current Ratio • Corporate Governance Variables:– Institutional investors’ holdings– Directors’ and executives’ holdings– CEO-chair separation (dummy variable)– Outside directors– CEO stock-based compensation

Results of Study • Statistics– Average of US$7,600 spent per employee on R&D– Average of US$72,000 spent per year on

compensation in stock-options for outside directors• Two hypothesis strongly supported– Positive and significant coefficient for stock option

compensation supports Hypothesis 1– Positive and significant coefficient for the interaction

supports Hypothesis 2

Results of Study

• Low stock-option compensation negative relationship between outside directors and R&D intensity

• High stock-option compensation becomes more positive

Key Points• Outside directors are more active in strategic

decisions• Reduces outside directors’ aversion to risk• Stock-option compensation and board

independence are complementary measures• Boards can become effective guardians of

shareholders’ interests• Governance mechanisms work together to align

agent behaviour with shareholder preferences

Key Points

• Relationship between the representation of outside directors and firms’ R&D intensity is moderated by stock-option compensation

• Extension of traditional bilateral agency model towards a two-agent model

• Stock-option pay gives agents an incentive to adopt rather than avoid risk projects

Limitations of Study

• Beyond scope to conclude whether the R&D level attained from stock-based compensation is optimal for shareholders

• Sample is composed of large US firms• Sample ends at the year 2000• Study did not control for the wealth effects

with respect to outside directors’ behaviour

CEO stock options pay and R&D spending: a behavioural agency explanation

Jianfeng Wu, Rungting Tu

Conflicting Viewpoints

• Traditionally theorists praised stock option compensation because it aligns the interests of shareholders and management

• Others argue that this form of executive compensation fails to address the long term interests of shareholders

Risk-Averse Management

• It is within the realm of CEO responsibility to make decisions regarding resource allocation to R&D

• R&D is risky because of high uncertainty and long time frame required for projects

• Management may be more risk-averse than shareholders due to personal wealth in company stock options

Risk-Taking Management

• CEO wealth from stock options cannot materialize if the stock price is below the exercise price

• It takes several years for CEOs to have their stock options fully vested

• These characteristics of stock options support the argument that management may be more likely to take risks

Slack Resources & Firm Performance

• The Buffer Argument– Slack is a product of strong firm performance and

has a positive impact on R&D spending– Leads to continued strong performance

• The Waste Argument– Believes slack resources are wasteful and lead to

managerial self-interest• Firm performance influences organizational

search

Slack Resources & Firm Performance

• Hypothesis 1– CEO stock option pay will be positively correlated

with R&D spending when firm slack is high rather than low

• Hypothesis 2– CEO stock option pay will be more positively

correlated with R&D spending when firm performance is high rather than low

Overview

• Study applies the behavioural perspective to investigate the relationship between CEO stock option pay and a firm’s R&D spending

• Argues linkage is contingent on two contextual factors:– Slack resources– Firm performance

• Both influence management’s perception of the downside risk associated with R&D investment

Sample

• Firms listed in the S&P 500 where R&D expenditures are of great importance to firm performance– Pharmaceuticals– Chemicals– Electronics– Aerospace

Variables

• Dependant– R&D expenditure per employee

• Independent– CEO stock option – Slack• Absorbed, unabsorbed and potential

– CEO stock ownership, current compensation, restricted stockholding and long term incentives

Variables continued…

• Control– Past R&D spending– Diversification– Firm growth opportunity– Industry dummies (omitted chemical industy)– Year dummies (omitted 2002)

Hypothesis #1

THE MORE SLACK RESOURCES A STOCK OPTION-PAID CEO HAS AT THEIR DISPOSAL, THE

HIGHER R&D SPENDING WILL BE.

Basis of Hypothesis

• When starting a new project, CEO’s consider:(1) Large investments required for acquisitions and

R&D of new project(2) Extra resources required to pay for these

activities• Reason for (2); the more extra resources

already owned, the less need for debt and less potential for loss

Basis of Hypothesis

• CEOs with an abundance of slack resources take more risks with R&D for a higher payoff

• CEOs with few slack resources prefer short-term gains to make themselves look better

• Stock OPTIONS are safe if a risk doesn’t pay off (don’t exercise) but is lucrative if it does

• R&D repercussions of these states are “Local Technology Search” and “Distant Tech Search”

Technology Searches

• “Local” = short-term incremental improvements on existing technology

• “Distant” = exploratory research potentially creating new influential technologies

• Availability of slack resources gives CEOs a buffer that enables them to research distant technologies without sacrificing short-term gains

Results

Low High20

25

30

35

40

45

50Moderating Role of Absorbed Slack

Low Performance High Performance

CEO Stock Option Pay

R&D

Spen

ding

Results

• Graph shows large support for the theory• With high slack, as CEO stock option pay increases

R&D spending increases• With low slack, as CEO stock option pay increases

R&D spending decreases• Results indicate the large motivational role stock

option pay plays on R&D spending

*note: stock OPTION pay is not the same as stock OWNERSHIP pay

Hypothesis #2

CEO stock option pay will be more positively associated with R&D spending

when firm performance is high than when firm performance is low

Performance Interaction

• Argues that level of performance influences:1. Management attention to R&D2. Available resources for R&D

Poor Performance Good Performance

• Pressure for immediate solutions• Short term focus (ie. Promotions

and advertising) to address problems

• Invest less in R&D as these investments are more future oriented

• Slack resources accumulate• Greater resources for R&D• Provides “buffer of risk” for top

management• Pay more attention to future

development such as R&D

CEO Interaction

Poor Performance

Value of options will decrease unless action is taken

Potential wealth losses for top

managers

Good Performance

Value of options can increase if R&D

projects are successful

Incentive to increase R&D expenditures; possible increase in

wealth for top managers

Results

Low High15

20

25

30

35

40Moderating Role of Firm Performance

Low Performance High Performance

CEO Stock Option Pay

R&D

Spen

ding