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 STOCKOPTION 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 shortterm 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
Moderating Role of Absorbed Slack
50
R&D Spending
45
40
35
30
25
20
Low
High
CEO Stock Option Pay
Low Performance
High Performance
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&D
2. 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
Moderating Role of Firm Performance
R&D Spending
40
35
30
25
20
15
Low
High
CEO Stock Option Pay
Low Performance
High Performance