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

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.

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Notes

  1. 1.

    FASB Statement 141 and 142 changed the accounting treatment of mergers and acquisitions. Effective July 1, 2001, the pooling-of-interest method is prohibited, and goodwill and indefinite-lived intangible assets are no longer amortized and should be tested for impairment utilizing a new methodology. This change is likely to enhance the value relevance of the accounting measures in mergers and acquisitions and accentuate the relation studied in this paper.

  2. 2.

    The high-tech industries are as defined by the SDC database, from where I obtain acquisition transaction values, which is used as one of the measures of the acquired technologies in the regression analyses.

  3. 3.

    Empirical results are robust to alternative definitions of cash (cash plus marketable securities divided by current liabilities, or cash plus marketable securities minus current liabilities, or simply cash plus marketable securities).

  4. 4.

    Shadow price refers to the part of the acquisition price paid for the target firm’s R&D investment.

  5. 5.

    The detail about this type of organizations can be found in Beatty, Berger, and Magliolo (1995).

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Acknowledgements

This paper is based on my work as a Ph.D. student at MIT Sloan School of Management. I am indebted to my advisors at MIT, S.P. Kothari, Joseph Weber and Richard Frankel for their guidance and encouragement. I am also grateful for helpful comments from an anonymous referee, Shane Dikolli, Wayne Guay, Ross Jennings, Bill Kinney, Ying Li, Volkan Muslu, George Plesko, Karen Sedatole, Peter Wysocki, JoAnne Yates, Jieying Zhang and seminar participants at MIT and UT Austin. I thank Ying Li for kindly sharing with me some of the data from her research on CEO compensation.

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Correspondence to Yanfeng Xue.

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Xue, Y. Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation. Rev Acc Stud 12, 659–690 (2007). https://doi.org/10.1007/s11142-007-9039-y

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Keywords

  • R&D
  • Mergers and acquisitions
  • Compensation
  • Technology

JEL Classifications

  • M41—Accounting
  • J33—Compensation packages
  • O31—Innovation and invention: processes and incentives
  • G34—Mergers and acquisitions