In our paper, Executive Compensation and Research & Development Intensity, which was recently made publicly available on SSRN, we examine the mediating effect of R&D intensity on the weights on signals of ability and financial performance measures in executive compensation contracts. There are many prior studies that investigate the impact of R&D intensity on total executive compensation (e.g., Dechow and Sloan 1991; Kwon and Yin 2006; Cheng 2004). However, prior studies did not incorporate adverse selection in their analysis. In other words, they did not investigate how R&D intensity affects the role of managerial ability in executive compensation. In contrast, we investigate how R&D intensity impacts the weights placed on human capital measures such as technical work experience, science and engineering degrees, and past experience in R&D intensive firms.
We have two main contributions to the executive compensation literature. First, we find that the weights on our proxies for managerial ability (technical work experience and relevant education) in executive compensation are higher for R&D intensive firms. Since R&D intensity increases the complexity of executives’ jobs, the marginal return on ability should be higher in R&D intensive firms. In particular, being knowledgeable in the field of technology is helpful in determining long-term strategy, competing with competitors, managing the R&D labor force, and protecting intangible assets. Therefore, in optimal incentive contracts, the weight on CEO ability should increase with R&D intensity.
Additionally, our results show that the weights on both accounting and stock returns in total compensation decrease with R&D intensity. The decreasing weight on accounting returns is due to the decreasing value-relevance of accounting measures in R&D intensive firms. The decreasing weight on stock returns is due to the low precision of stock returns for R&D intensive firms.
Prior studies document that R&D intensive firms grant more stock options and restricted stocks to their executives (Kole, 1997; Smith and Watts, 1992). Consistent with their findings, our results show that the proportion of equity-based pay in total compensation is positively related to R&D intensity. In other words, equity-based pay (long-term incentives) rather than cash pay (short-term incentives) are dominant in R&D intensive firms. This may be because capital markets need much more time to recognize the value of R&D investments. In the short-term, due to the high information asymmetry between investors and managers in R&D intensive firms, stock prices are less informative of the intrinsic value of these firms. The weights on stock returns therefore are negatively associated with R&D intensity.
The full paper is available for download here.