This study aims to investigate whether compensation committees provide the chief executive officers (CEOs) with incentives to undertake “income-decreasing” but potentially “value-enhancing” innovation expenditures. The authors specifically analyze pay–performance relationships for innovative firms relative to all other firms. This study is critical because innovation is expensive and has uncertain outcomes.
Using alternative accounting performance measures and market performance measures, the authors estimate an econometric model of CEO compensation in innovative firms that incorporates the interaction of endogenous innovation and firm performance.
The authors document an incremental positive association between changes in accounting performance measures and CEO compensation changes in innovative firms relative to other firms. This sensitivity of executive pay to firm performance is higher for firms that innovate. These results support the hypothesis that compensation committees provide incentives to carry out risky innovation by tying executive compensation more closely to firm performance. This finding survives a battery of sensitivity tests.
The implications of this study are significant. Capital needs to support risky research and development investments (Tidd and Besant, 2018; Baldwin and Johnson, 1995) form the basis of innovative firms' operations. Considering these expenses, if CEOs, who play a critical role in the scanning, adapting and implementing innovative needs in a firm, are not protected and compensated for making risky choices, the entire investment itself will be threatened. Hence, the findings reiterate and support earlier findings that speak to the importance of compensating CEOs to make high-risk investments that will lead to long-term economic and financial gains for the firm when the innovative behaviors result in competitive market shares and profits.
The original work is related to the investigation of pay–performance sensitivity in the presence of innovation, which has not been fully investigated in prior literature.
