n important part of a country's technological
advancement comes from the efforts of companies
to innovate. Managers are the key decision makers
on how company resources are spent, and their decision to
invest in cutting-edge projects may be influenced by internal
and external corporate governance mechanisms that enhance
or diminish the incentive to innovate.
How a manager is compensated and how closely shareholders
are able to keep an eye on a manager's performance,
for example, can affect his or her choice of projects. Antitakeover
laws that determine how easy or difficult it will be
for investors to buy out shareholders—in the so-called market
for corporate control—can likewise affect a manager's
decision to innovate. For instance, one strand of literature
argues that laws that hinder the market for corporate control
promote managerial slack and discourage managers from
investing in risky but innovative activities, because there is
very little threat of a takeover and thus of managers losing
their jobs. A contrasting view asserts that laws that reduce
takeover pressure foster innovation because managers are
encouraged to take a longer-term view when making investment
Though previous studies have looked at how innovation
is affected by either internal or external corporate
governance mechanisms, very little research has focused
on how these two factors influence each other, according to
University of Chicago Booth School of Business professor
Haresh Sapra. "There's pressure from outside and inside
the company, and we were interested in studying how these
two forces interact," says Sapra. The study, titled "Corporate
Governance and Innovation: Theory and Evidence"
by Sapra and co-authors Ajay Subramanian of Georgia
State University and Krishnamurthy Subramanian of the
Indian School of Business, examines how the interaction
of external mechanisms, such as state anti-takeover laws,
and internal mechanisms, such as managers' compensation
contracts and monitoring of managers by large shareholders,
affect managers' choice of projects.
The authors find that both very severe and very lenient
anti-takeover laws give managers an incentive to choose
highly innovative projects. An environment with moderate
takeover pressure, on the other hand, leads to less innovation.
In addition, intense monitoring of managers by large
shareholders encourages more innovation because managers are more likely to do what shareholders want when their
performance is closely scrutinized.
Managers' Perks and the Takeover Premium
The authors build a model in which the manager chooses
between a very risky yet possibly mold-breaking project and
a less risky, routine project. Suppose the manager of a pharmaceutical
company could invest in either inventing a new
drug or manufacturing a generic substitute for an existing
drug. Inventing a new drug is riskier since a greater portion
of its uncertainty lies in establishing the new drug's viability.
On the other hand, manufacturing a generic substitute of an
already existing drug would mostly entail a marketing risk. If
successful, the riskier and more innovative project is expected
to have a higher payoff.
The company can be acquired by another firm. The
severity of anti-takeover laws determines the company's
bargaining power when negotiating with the raider, which is
reflected in the takeover premium offered by the acquirer.
If the takeover pressure is high because anti-takeover laws
are lenient, then the premium that raiders are willing to pay
rises as potential buyers outbid each other. Because the raider
intends to create value by turning the company around, a
company is acquired only if it has been performing below a
certain threshold. Thus, companies with innovative projects
are more likely to be a target because riskier projects tend to
have more variable returns.
The manager's compensation contract includes an equity
stake in the company and a severance payment in the event
of a takeover. Apart from the compensation a manager
receives, he or she also derives private control benefits as
head of the company. Being a CEO, for instance, comes with
certain perks like being able to take on projects or buying
companies that the CEO likes, sometimes at the expense of
shareholders. However, these benefits are "private" in the
sense that shareholders cannot write a contract to make sure
that managers do not extract such perks. The manager's private
control benefits decline if large shareholders in the firm
can monitor the manager more intensely. If the company is
acquired by another firm, the manager must cede these benefits
to the raider.
Choosing How Much to Innovate
Managers want to maximize the value of their company and
do not want to lose the private control
benefits that come along with
the job. When faced with the decision
to choose a project, they know
that selecting the more innovative
project increases the chances that
the firm will be taken over and thus
the possibility that they will no longer
head the company. However,
the higher likelihood of a takeover
means that shareholders will be offered a large premium,
which also makes managers better off. Thus, managers must
weigh the higher expected takeover premium against the
expected loss of control benefits if they choose the more
The authors propose that when the takeover pressure that
a firm faces is very low, perhaps because anti-takeover laws
in a particular state are severe, then both the expected takeover
premium and the expected loss in control benefits are
insignificant because it is unlikely that the firm will fall into
the hands of a raider. Managers do not have to worry about
losing their jobs and consequently their control benefits.
Thus, they end up choosing the highly innovative project that
generates the highest value for the company.
On the other hand, managers will also choose the more
innovative project if the threat of a takeover is very high.
In this case, the expected loss in control benefits will be
large, but the takeover premium that managers expect to
receive will be even bigger as potential buyers compete in
an environment where the market for corporate control is
very active. In other words, the expected takeover premium
dominates the expected loss in control benefits. Thus, managers
choose the more innovative project in order to increase
the chances of obtaining that premium.
What about environments where the takeover pressure
is moderate, that is, when the threat of a takeover is neither
very high nor very low? The authors argue that in this type of
environment, managers' fear of losing their jobs and their
control benefits dominates the takeover premium they might
get from selecting the highly innovative project. Therefore,
managers choose not to innovate in order to stay at the
helm of their company. Altogether, these results produce
a U-shaped relationship between innovation and takeover
pressure: managers choose the more innovative project only
when the threat of a takeover is either very high or very low.
However, if shareholders monitor the performance of
managers more closely, it becomes more costly for managers
to extract the perks bestowed by their position. Managers'
objectives will become more aligned with the interests of
shareholders, who always prefer more innovation because
it gives them the biggest payoff. Thus, managers are more
likely to choose the highly innovative project. In addition, an
increase in the intensity of monitoring makes the decision
to innovate less sensitive to changes in takeover pressure,
resulting in a flatter U-shaped curve.
Anywhere but the Middle
The authors test their model and its predictions using three
measures of innovation: the ratio of a firm's research and
development (R&D) expenditures to sales, the number of
patents filed by a U.S. firm at the U.S. Patent Office, and the
number of citations made to such patents. Takeover pressure
in each state is measured by the number of anti-takeover
statutes, which consists of laws that make takeovers very
costly from the perspective of the acquirer. One example of
an anti-takeover law is whether a firm can adopt a poison
pill—an anti-takeover tactic adopted by a company to deter
takeover bids or force bidders to pay a huge premium if they
want to acquire the company. Finally, the intensity of monitoring
is measured by the number of institutional and public
pension fund shareholders who own more than 5 percent of
a firm's outstanding shares, as well as the total percentage of
shares owned by these so-called block holders.
Indeed, the study finds that innovation varies in a
U-shaped manner with the anti-takeover index. When the
value of the anti-takeover index in a state is very low, a onepoint
increase in this index decreases the R&D-to-sales
ratio by 28 percent a year. Moreover, when the value of the
anti-takeover index is very high, a one-point increase augments
the same innovation measure by 30 percent a year.
Thus, both very lenient and very strict anti-takeover laws
lead to more innovation. More intense shareholder monitoring
is also associated with greater innovation and flattens
the U-shaped relationship between takeover pressure
The study's results are especially relevant to the ongoing
debate on the importance of the market for corporate control
in fostering innovation, and present evidence that the
two competing views described before are "locally" correct.
When the threat of a takeover is very high, easing anti-takeover
laws may lead to a decline in highly innovative projects
because managers worry less about performing well and losing
their jobs. This is consistent with the "quiet life" view.
When takeover pressure is very low, on the other hand, stimulating
the market for corporate control likewise decreases
a manager's incentive to innovate and allows "managerial
myopia" to set in, because the manager is unsure of how long
he or she will stay in control of the company.
The results also suggest that the way to encourage corporate
innovation is either through state anti-takeover laws
that are practically non-existent as in California, or strong
enough to significantly deter takeovers as in Massachusetts.
Intense shareholder monitoring promotes innovative activities
as well, and seems to be most effective when companies
face moderate levels of takeover pressure.
"Corporate Governance and Innovation: Theory and Evidence."
Haresh Sapra, Ajay Subramanian, and Krishnamurthy Subramanian.