In the paper, Takeover Defenses as Drivers of Innovation and Value-Creation, forthcoming in the Strategic Management Journal, I analyze the role of anti-takeover provisions in ameliorating agency conflicts of managerial risk aversion in certain types of companies.

The desirability of anti-takeover provisions (ATPs) is a contentious issue. ATPs can lead to shareholder wealth-destruction by insulating managers from disciplinary takeovers and enabling them to engage in empire building. However, without ATPs, managers of hard-to-value (HTV) firms, which might trade at a discount due to valuation-difficulties, are exposed to ‘opportunistic takeovers’ (which aim to take advantage of low stock prices), potentially causing managerial myopia and under-investment in innovative projects. Thus, in HTV firms, ATPs might serve as credible commitments to encourage managers to make value-creating investments, but in easier-to-value firms, they might lead to inefficient governance.

…continue reading: Takeover Defenses as Drivers of Innovation and Value-Creation

A recent book by Josh Lerner and a recent article in the Journal of Public Economics has asserted that government venture capital programs in Europe have displaced or crowded out private venture capital. The result of work such as this has been to place pressure on government bodies around the world to remove or replace their existing governmental programs. In the aftermath of the financial crisis, venture capital markets around the world themselves have been in crisis. So, it is particularly timely to address the issue of whether or not government venture capital programs in regions such as Europe really have in fact crowded out private venture capital programs.

As pointed out in this Economist article and in my recent commentary and my review article, the idea that government programs crowding out private venture capital in Josh Lerner’s book and in the Journal of Public Economics is based on empirical measures that are completely flawed. The empirical tests supporting crowding out are based on methodologies that rank the Austrian and Hungarian venture capital markets as being the best in the Europe, and the U.K. venture capital market as being the worst in Europe (I am not kidding).

…continue reading: Measuring the Effectiveness of Public Policy Towards Venture Capital

In the paper, R&D and the Incentives from Merger and Acquisition Activity, forthcoming in the Review of Financial Services, my co-author (Alexei Zhdanov of the University of Lausanne and the Swiss Finance Institute) and I examine how the incentives to innovate differ between large and small firms and whether the M&A market hinders or promotes innovative activity. Previous literature has documented that R&D and innovation decreases post-acquisition and has attributed this effect to large firms stifling innovative activity. Using recent data on pre-merger R&D activity, we show that this view is flawed. Rather than large firms stifling R&D by small firms, we show theoretically and empirically how mergers can stimulate R&D activity of small firms. Thus, ex ante R&D rises and then falls naturally after acquisition as the pre-merger stimulus effect wears off.

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In our forthcoming American Economic Review paper, Innovation and Institutional Ownership, we examine the incentives to innovate at the firm level by studying the relationship between innovation and institutional ownership. Innovation is the main engine of growth. But what determines a firm’s ability to innovate? Innovating requires taking risk and forgoing current returns in the hope of future ones. Furthermore, while any type of financing is plagued by moral hazard and adverse selection, the financing of innovation is probably the most vulnerable to these problems (Arrow, 1962) since the information that needs to be conveyed is hard to communicate to outsiders. This paper is an attempt at analyzing the corporate governance of innovation and more specifically the role of institutional owners in fostering (or hindering) innovation.

While the ability to diversify risk across a large mass of investors makes publicly traded companies the ideal locus for innovation, managerial agency problems might undermine the innovation effort of these companies. In publicly traded companies, the pressure for quarterly results may induce a short-term focus (Porter, 1992). And the increased risk of managerial turnover (Kaplan and Minton, 2008) might dissuade risk-averse senior managers from this activity. Finally, innovation requires effort and “lazy” managers might not exert enough of it. Hence, it is especially important to study the governance of innovation in publicly traded companies, which account for a large share of the private investments in research and development (R&D).

…continue reading: Innovation and Institutional Ownership

In our paper, Industry Expertise on Corporate Boards, which was recently made publicly available on SSRN, we propose and study a measure of board industry expertise. The question of who should sit on corporate boards has attracted significant academic and regulatory efforts in recent years. For example, on December 16, 2009, the U.S. Securities and Exchange Commission (SEC) released final proxy disclosure enhancement rules. Among other directives, these rules require registrants to “disclose for each director and any nominee for director the particular experience, qualifications, attributes or skills that qualified that person to serve as a director.”  A prominent feature of these disclosures has been an emphasis on related industry experience. In its first proxy filing under these rules, Hewlett-Packard stated that director Marc L. Andreessen “is a recognized industry expert and visionary in the IT industry” who has “extensive leadership, consumer industry and technical expertise” through his positions at and service on the boards of public and private technology companies.  Other major firms making similar claims include Coca-Cola Co., Wal-Mart Stores, and Bank of America.

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My article, Too Complex to Depict? Innovation, ‘Pure Information,’ and the SEC Disclosure Paradigm, published in June in the 2012 symposium issue of the Texas Law Review, offers a new conceptualization of the SEC disclosure paradigm that has been in place since the Depression, shows how that paradigm has been undermined by the modern process of financial innovation, and offers possible ways ahead. Since its creation, the SEC’s totemic philosophy has been to promote a robust informational foundation. As a necessary corollary, the SEC’s approach has been incremental, generally not venturing into substantive decision-making (as to stock prices or otherwise).

The article starts by suggesting that this disclosure philosophy has always been largely implemented through what can be conceptualized as an “intermediary depiction” model. An intermediary—e.g., a corporation issuing shares—stands between the investor and an objective reality. The intermediary observes that reality, crafts a depiction of the reality’s pertinent aspects, and transmits the depiction to investors. Securities law directs depictions to be accurate and complete. “Information” is conceived of in terms of, if not equated to, such depictions.

…continue reading: Innovation, “Pure Information,” and the SEC Disclosure Paradigm

Corporate managers, bankers, and policy makers alike have expressed concerns that the recent dearth of initial public offerings (IPOs) has caused a breakdown in the engine of innovation and growth. In the paper, Does Going Public Affect Innovation?, which was recently made publicly available on SSRN, I explore whether the transition to public equity markets indeed affects innovation, and if so, how. Theoretically, the effect of IPOs on innovation is ambiguous. On the one hand, going public provides improved access to capital that may allow firms to enhance their innovative activities; on the other hand, market pressures and potential departure of employees following the IPO may lead to opposite results.

To answer this question, I use standard patent-based metrics to capture changes in innovative activity in the years around the IPO and focus on three important dimensions of firms’ innovative activity: internally generated innovation, the productivity and mobility choices of individual inventors, and the acquisition of external innovation.

…continue reading: IPOs and Innovation

In our forthcoming Journal of Finance paper, Are Overconfident CEOs Better Innovators?, we find that over the 1993 to 2003 period, CEO overconfidence is associated with riskier projects, greater investment in innovation, and greater innovation as measured by the number of patent applications and patent citations even after controlling for the amount of R&D expenditures. In other words, the R&D investments of overconfident CEOs are more productive in generating innovation. However, greater innovative output of overconfident managers is achieved only in innovative industries. We also find evidence that overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value, especially within innovative industries. We find that overconfidence remains a strong and significant predictor of innovation even when we remove managers with short tenures at their firms, which suggests that the endogenous hiring of overconfident managers by innovative firms is not the main driver of our findings.

The results of this study have a bearing on the usual presumption that overconfidence is undesirable. Business commentators often point to examples of headstrong, overconfident CEOs who made disastrous decisions. However, the chance of a big defeat may be a corollary to the chance of great victory, so the lesson to draw from examples is unclear. A more serious charge is provided by the evidence of Malmendier and Tate (2008) that the market reacts more negatively to acquisitions made by overconfident CEOs. This dark side to CEO overconfidence might seem to suggest that the CEO selection process should be designed to filter out oversized egos, or that compensation and governance should be designed to severely constrain such CEOs.

…continue reading: Are Overconfident CEOs Better Innovators?

In our paper, Investment Cycles and Startup Innovation, which was recently made publicly available on SSRN, we examine how the environment in which a new venture was first funded relates to their ultimate outcome. New firms that surround the creation and commercialization of new technologies have the potential to have profound effects on the economy. The creation of these new firms and their funding is highly cyclical (Gompers et al. (2008)). Conventional wisdom associates the top of these cycles with negative attributes. In this view, an excess supply of capital is associated with money chasing deals, a lower discipline of external finance, and a belief that this leads to worse ventures receiving funding in hot markets.

However, the evidence in our paper suggests another, possibly simultaneous, phenomenon. We find that firms that are funded in “hot” times are more likely to fail but create more value if they succeed. This pattern could arise if in “hot” times more novel firms are funded. Our results provide a new but intuitive way to think about the differences in project choice across the cycle. Since the financial results we present cannot distinguish between more innovative versus simply riskier investments, we also present direct evidence on the quantity and quality of patents produced by firms funded at different times in the cycle. Our results suggest that firms funded at the top of the market produce more patents and receive more citations than firms funded in less heady times. This indicates that a more innovative firm is funded during “hot” markets.

…continue reading: Investment Cycles and Startup Innovation

The working paper, Complexity, Innovation and the Regulation of Modern Financial Markets, which was recently made publicly available on SSRN, was motivated by two observations.

First, the perfect market assumptions underpinning the canonical theories of financial economics – modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model, and the efficient market hypothesis – are increasingly unreflective of how many modern financial markets work in practice.  More specifically, these theories share a common and highly stylized view of financial markets, one characterized by perfect information, the absence of transaction costs and rational market participants.  Yet in reality, of course, financial markets rarely (if ever) strictly conform to these assumptions.  Information is costly and unevenly distributed; transaction costs are pervasive, and market participants frequently exhibit cognitive biases and bounded rationality.  Despite these seemingly uncontroversial facts, however, the empirically (con)testable assumptions of conventional financial theory have been transformed into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources.

…continue reading: Complexity, Innovation and the Regulation of Modern Financial Markets