Longterm incentives Moqi GroenXu London School of Economics

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Long-term incentives Moqi Groen-Xu, London School of Economics Prepared for LBS governance conference June

Long-term incentives Moqi Groen-Xu, London School of Economics Prepared for LBS governance conference June 2, 2015

Long-term incentives: why? how? …and what are the effects?

Long-term incentives: why? how? …and what are the effects?

Why should we set long-term incentives? Method Data Yearly Qrt/Mth Summary Whatevs 3/21

Why should we set long-term incentives? Method Data Yearly Qrt/Mth Summary Whatevs 3/21

Example Classic Example Noda-Bower (1996): Investment into wireless communication in the 1980 s high

Example Classic Example Noda-Bower (1996): Investment into wireless communication in the 1980 s high uncertainty about potential product scope and technology not clear Method Data Yearly Qrt/Mth Summary Whatevs 4/21

US West vs Bell. South US West • • one of “Bells” from AT&T

US West vs Bell. South US West • • one of “Bells” from AT&T breakup required quick break-even and high net income contribution Bell South • • • one of “Bells” from AT&T breakup emphasis on growth in project selection CEO with “pet projects” Strategy • • “cream-skimming” diversification into real estate • heavy investment into cellular market Whatevs 5/21

Two stages of investment (Manso) 1 • 2 Exploration • learn about payoff distribution

Two stages of investment (Manso) 1 • 2 Exploration • learn about payoff distribution of ideas Method Data Yearly Exploitation invest into project with best (known) payoff distribution Qrt/Mth Summary Whatevs 6/21

How can we set long-term incentives? Method Data Yearly Qrt/Mth Summary Whatevs 7/21

How can we set long-term incentives? Method Data Yearly Qrt/Mth Summary Whatevs 7/21

How can we set long-term incentives? Equity compensation Method Data Fixed-term contracts Yearly Qrt/Mth

How can we set long-term incentives? Equity compensation Method Data Fixed-term contracts Yearly Qrt/Mth Summary Whatevs 8/21

Two studies 1 2 Compensation Contract length Joint work with • Alex Edmans •

Two studies 1 2 Compensation Contract length Joint work with • Alex Edmans • Luis Goncalves-Pinto • Yanbo Wang Joint work with • Juanita Gonzalez-Uribe Looks at the effects of equity vesting on the timing of news releases Looks at the effects of contract horizon on innovation (patenting activity) Method Data Yearly Qrt/Mth Summary Whatevs 9/21

Long-term equity compensation • Example: John Eyler/Toys”R”Us • Source: Filing 4/Proxy statement footnotes •

Long-term equity compensation • Example: John Eyler/Toys”R”Us • Source: Filing 4/Proxy statement footnotes • On average 3 years of vesting per grant Method Data Yearly Qrt/Mth Summary Whatevs 10/21

Equity vesting and sales Method Data Yearly Qrt/Mth Summary Whatevs 11/21

Equity vesting and sales Method Data Yearly Qrt/Mth Summary Whatevs 11/21

Fixed-term contracts Whatevs 12/21

Fixed-term contracts Whatevs 12/21

Patricia Russo at Lucent Appointment 2002 2003 2004 2005 2006 2007 T-5 T-4 T-3

Patricia Russo at Lucent Appointment 2002 2003 2004 2005 2006 2007 T-5 T-4 T-3 T-2 T-1 T Whatevs 13/21

Contract termination Data Results Qrt/Mth Summary Whatevs 14/25

Contract termination Data Results Qrt/Mth Summary Whatevs 14/25

What are the effects of long-term incentives? Method Data Yearly Qrt/Mth Summary Whatevs 15/21

What are the effects of long-term incentives? Method Data Yearly Qrt/Mth Summary Whatevs 15/21

Strategic news releases News releases lead to a temporary increase in stock price and

Strategic news releases News releases lead to a temporary increase in stock price and trading volume Executives personally benefit from news releases shortly before they sell Method Data Yearly Qrt/Mth Summary Whatevs 16/21

Strategic news releases in equity vesting months Method Data Yearly Qrt/Mth Summary Whatevs 17/21

Strategic news releases in equity vesting months Method Data Yearly Qrt/Mth Summary Whatevs 17/21

Long term incentives in comparison Compensation schedule • • • Contract length • •

Long term incentives in comparison Compensation schedule • • • Contract length • • • Today: news releases Incentives for the upside Can be replenished over time: set long- and short term incentives at the same time Method Data Yearly Today: innovation Tolerance for failure Hard to replenish over time – “evergreen” contracts set incentives until the next renewal date Qrt/Mth Summary Whatevs 18/21

Innovation 0. 7 95% Confidence Interval Scaled patent citations 0. 6 Coefficient Estimate 0.

Innovation 0. 7 95% Confidence Interval Scaled patent citations 0. 6 Coefficient Estimate 0. 5 0. 4 0. 3 0. 2 0. 1 0 T-5 T-4 T-3 T-2 Time to contract expiration T-1 Whatevs 19/21

Exploration and exploitation 0. 05 Technological focus 0 -0. 05 T-4 T-3 T-2 -0.

Exploration and exploitation 0. 05 Technological focus 0 -0. 05 T-4 T-3 T-2 -0. 1 -0. 2 6 4 2 0 -2 • More focused (less dispersion throughout technology classes) • Less varied in quality variety -0. 15 8 T-1 CEOs with less time remaining under contract produce patents that are Quality variety • Less general (more dispersion across technology classes of subsequent innovations that cite the patent) • Less likely to be in a technology class new to the firm • Less likely to be filed by a new inventor • More likely to be based on prior innovations filed by the firm Whatevs 20/21

Long-term incentives 2 mechanisms: equity compensation fixed-term contracts 2 effects (today): news releases innovation

Long-term incentives 2 mechanisms: equity compensation fixed-term contracts 2 effects (today): news releases innovation