CEO INCENTIVES and CORPORATE INNOVATION

The Financial Review 53 (2018) 255–300
CEO Incentives and Corporate Innovation

Tu Nguyen
La Trobe University
Abstract
Using scaled wealth-performance sensitivity as my measure of Chief Executive Officer

(CEO) incentives, and utilizing cross-sectional variations in industry innovativeness, product
market competition and firms’ degree of exposure to the market for corporate control for
identification purposes, I find that higher long-term incentives that stem from CEO holdings
of unvested options are associated with greater subsequent corporate innovation in innova-
tive industries, competitive product markets, and firms more exposed to the threat of hostile
takeovers, that is, exactly where incentivizing innovation is a matter of necessity. I address
the endogeneity concerns with systems of simultaneous equations estimated using three-stage
least squares. A possible channel for the observed relation between unvested options-based
incentives and subsequent corporate innovation is that these incentives encourage managers to
undertake riskier projects to achieve long-term economic benefits.
Keywords: long-term incentives, vesting restrictions, corporate innovation, patents, citations
JEL Classifications: G34, O31
1. Introduction
Holmstrom (1989) refers to innovation projects as risky, unpredictable, long-
term, multistage, labor-intensive and idiosyncratic as they involve the exploration
Corresponding author: Department of Economics and Finance, La Trobe University, Bundoora, VIC 3086,
Australia; Phone: +61 3 9479 5608; E-mail: tu.nguyen@latrobe.edu.au.
I am grateful for helpful comments and suggestions from Srinivasan Krishnamurthy (the Editor) and an
anonymous referee. I also thank Jing Zhao, Sandy Suardi, and participants at the National Sun Yat-Sen
University’s Securities and Financial Markets Conference 2016. All errors remain my own.

C 2018 The Eastern Finance Association 255
256 T. Nguyen/The Financial Review 53 (2018) 255–300
of new untested approaches. Therefore, the agency costs associated with innova-
tion is likely to be high and designing incentive schemes to motivate innovation
is particularly demanding. Manso (2011) models the innovation process explicitly
and contrasts incentive schemes that motivate the exploration of new possibilities
and the exploitation of old certainties. Since exploration often involves sacrificing
short-term performance in order to achieve greater long-term success, Manso (2011)
shows that the optimal contract that motivates exploration exhibits tolerance for
failure in the short term and rewards long-term success. This empirical implication
is consistent with Lambert (1986), Holmstrom (1989), and Fudenberg, Holmstrom
and Milgrom (1990), among others. Taken together, these theoretical studies, though
adopting different approaches and focusing on different aspects of innovation activity,
highlight the importance of properly designed managerial incentives, in particular,
the importance of the long-term focus of these incentives in motivating innovation.
Furthermore, among the sources of equity-based incentives, options have different in-
centive value than stock. Specifically, owing to their convex payoff function, options
improve incentives to risk-averse agents. Therefore, stock options, as compared with
stock, may encourage managers to accept riskier projects (Lambert, 1986; Jackson
and Lazear, 1991; Feltham and Wu, 2001; Manso, 2011)—a category that innovation
projects clearly belong to.
In this study, I empirically examine two research questions that are consistent
with the empirical implications of Manso (2011) in the context of executive compen-
sation and motivating innovation. First, I investigate whether long-term incentives
that stem from the Chief Executive Officer (CEO)’s holdings of unvested options and
restricted stock are higher in firms operating in an environment where opportunities
for innovation abound and/or the needs for innovation are more urgent—innovative
industries and competitive product markets. Second, I examine whether these incen-
tives, in particular, unvested options-based incentives spur corporate innovation. I use
the number of patents granted to a firm and the number of citations received by each
patent as my measures of corporate innovation. For measures of CEO incentives, I
use the scaled wealth-performance sensitivity (the dollar change in the CEO’s wealth
for a percent change in firm value, scaled by annual total pay), advocated by Edmans,
Gabaix and Landier (2009).
With regard to the first question, I document that long-term incentives, in par-
ticular, unvested options-based incentives are significantly higher among firms in
innovative industries as well as among firms facing strong product market competi-
tion. Regarding the second question, the results from the baseline specification show
that a higher level of executive long-term incentives is associated with not only a
higher number of patents but also a higher impact of patents generated in the follow-
ing year. And the most detailed breakdown of incentive measures suggests that this
positive relation is driven by the CEO’s holdings of unvested options. Specifically,
for my sample of 13,279 firm-year observations over the 1992–2006 period, a one-
standard-deviation increase in executive incentives stemming from unvested option
holdings increases the number of year-adjusted patents in the following year by 2.0%
T. Nguyen/The Financial Review 53 (2018) 255–300 257
of its mean and the number of year-adjusted citations per patent in the following year
by 2.9% of its mean. Moreover, utilizing cross-sectional variations in industry inno-
vativeness and product market competition, I document that the relation is observed
only within innovative industries and industries with strong product market compe-
tition, that is, exactly where incentivizing innovation is a matter of necessity. While
the bulk of the CEO’s incentives can be attributed to his/her holdings of unrestricted
stock, short-term (vested) incentives do not appear to be associated with greater inno-
vation output. The evidence is thus consistent with my hypothesis that not all sources
of equity-based incentives are equal when it comes to motivating innovation. The
results also suggest that a traditional pay-for-performance sensitivity measure that
lumps together all types of equity-based compensation would likely fail to capture
any motivating effect of equity-based incentives on innovation. On a slightly different
note, utilizing cross-sectional differences in firms’ degree of exposure to the market
for corporate control, I show evidence consistent with the interpretation that firms
treat the adoption of antitakeover provisions and the design of executive incentive
compensation as substitutes when choosing their corporate governance structure to
motivate exploration and innovation. Overall, I view tests conducted within innova-
tive industries or competitive product markets or among firms more exposed to the
threat of hostile takeovers as more powerful ways to identify the effect of executive
incentives on innovation.
I fully recognize that establishing causality is empirically challenging due to
the potential endogeneity problems. The relation between executive incentives and
corporate innovation is likely determined in a dynamic process. Executive incentives
are structured to encourage value-enhancing efforts which, in turn, get remunerated
through incentive compensation. Alternatively, the relation could be spurious because
some unobserved factors simultaneously affect corporate innovation and executive
incentives. Therefore, I have employed various methods to address the endogeneity
concerns. In particular, I use three-stage least squares (3SLS) to estimate systems
of simultaneous equations that explicitly allow for the joint determination of next
year innovation output and current CEO incentives. I continue to find that unvested
options-based incentives motivate innovation.
Additionally, I show evidence suggesting that a possible channel for the ob-
served relation between unvested options-based incentives and subsequent corporate
innovation is that these incentives provide managers with greater incentives for risk
taking, as reflected in higher future firm risk. The increase in firm risk is achieved, in
part, through such avenues as implementing riskier corporate policies, in particular,
undertaking riskier investment projects, among which are innovation projects that
result in higher innovation output.
This paper is closely related to studies that examine the relation between in-
centives and corporate innovation (see, e.g., Clinch, 1991; Kole, 1997; Yanadori
and Marler, 2006; Lerner and Wulf, 2007; Sheikh, 2012; Ederer and Manso, 2013;
Gopalan, Milbourn, Song and Thakor, 2014). I contribute to this strand of literature by
employing a novel comprehensive incentive measure (Edmans, Gabaix and Landier,
2009) that reflects the stock of incentives stemming from the CEO’s holdings of
shares and options and represents a pure measure of incentives undistorted by firm
size. Furthermore, using various identification methods, I show robust and consistent
evidence that, among the different sources of equity-based incentives, it is unvested
options-based incentives that exhibit the desirable innovation-motivating effect, as
unvested options uniquely meet two conditions for encouraging higher risk taking for
the purpose of achieving greater long-term success—a long-term focus and a convex
payoff function. In addition, by investigating the implication of CEO equity-based
incentives on the volatility of future firm stock returns and the riskiness of firm
investment and financial policies, I provide deeper insight into possible channels
for the observed relation between unvested options-based incentives and subsequent
corporate innovation. As such, this study provides direct empirical evidence support-
ing Manso’s (2011) conclusion that the optimal innovation-motivating compensation
contract that exhibits tolerance for failure in the short term and rewards success in the
long term should include stock options with long vesting periods. This has practical
implications for designing executive incentive schemes to encourage managers to
undertake innovation projects.
This study is also related to a growing body of literature that examines the relation
between corporate innovation and different corporate governance mechanisms such as
external takeover pressure (Atanassov, 2013; Sapra, Subramanian and Subramanian,
2014), ownership by institutional investors (Aghion, Van Reenen and Zingales, 2013),
practices adopted by venture capitalists (Tian and Wang, 2014), and the attitude
and vision that a CEO brings to the job (Hirshleifer, Low and Teoh, 2012). My
work contributes to this literature by providing evidence suggesting that firms treat
external governance (insulation from the market for corporate control) and internal
governance (executive incentive compensation) as substitutes when they choose their
corporate governance structure to motivate innovation.
Finally, my paper adds to the strand of literature that explores the consequences
of liquidity restrictions on CEO holdings. In the context of corporate governance,
the rationale for using liquidity restrictions is to address agency problems and retain
managers as well as key employees. However, a number of studies such as Hall and
Murphy (2002), Kahl, Liu and Longstaff (2003), and Cai and Vijh (2005) point to the
dark side of liquidity restrictions. That is, these restrictions can significantly increase
the cost of the lack of diversification and lower the value of a firm’s stock and option
holdings to managers. The costs imposed by these liquidity restrictions consequently
make them a more costly corporate governance tool and less effective at reducing
agency costs. In contrast, this study shows evidence pertaining to a bright side of
vesting restrictions on CEO stock and options, that is, long-term unvested incentives
in the form of unvested options motivate innovation.
The paper proceeds as follows. Section 2 describes my data and empirical
methodology. In Section 3, I present and analyze the results from the baseline spec-
ification and several robustness checks. In particular, I discuss the approaches that I
use to address the endogeneity concerns. Section 4 concludes.
2. Data and methodology

2.1. Sample selection
To construct the sample, I combine executive compensation data from Execu-
Comp, patent-related data from the National Bureau of Economic Research (NBER)
patent database, accounting data from COMPUSTAT, and institutional ownership
data from Thomson 13F database. Firm-year observations with missing data on CEO
wealth-performance sensitivity and any of the main control variables are deleted. I
exclude financial and utility firms. The final sample consists of 13,279 firm-year
observations associated with 1,900 firms from 1992 through 2006.
2.2. Variable measurement

2.2.1. Measuring innovation
I construct innovation variables using the latest version of the NBER patent
database that contains patent and citation information from 1976 to 2006. My first
measure of innovation is the number of patent applications filed by a firm in a given
year that are eventually granted. Hall, Jaffe and Trajtenberg (2001) recommend using
application year because the actual timing of the patented innovation is closer to the
application year than to the subsequent grant year.1 There is, on average, a two-year
lag between patent application and patent grant. This in turn leads to a truncation bias
in patent counts toward the end of the sample period. As suggested by Hall, Jaffe
and Trajtenberg (2001), I include year fixed effects in the regressions to address this
truncation issue. Additionally, following Atanassov (2013), I construct an adjusted
measure of patent count by scaling the number of patents for each firm-year by the
average number of patents of all firms in the NBER patent database for that year.
Though intuitive and straightforward, a simple count of patents does not distin-
guish breakthrough innovations from incremental technological discoveries. A more
accurate measure of the importance and quality of a firm’s innovation output is patent
citations. Hence, my second measure of innovation is the number of citations per
patent. This measure, however, also suffers from a truncation bias because patents
tend to receive citations over a long period after the patents are granted. I follow
the recommendations of Hall, Jaffe and Trajtenberg (2001) and adjust the citation
count of each patent in three different ways. For the first adjustment, I multiply each
patent’s citation count by the weighting index from Hall, Jaffe and Trajtenberg (2001,
2005) that is created by econometrically estimating the distribution of the citation
lag.2 For the second adjustment, I scale each patent’s citation count by the average
1 Hall, Griliches and Hausman (1986) show that patent applications are generated nearly contemporane-
ously with research and development expenditures.
2 The citation truncation weight index is provided in the NBER patent database.
citation count of all patents in the same year. And for the third adjustment, I scale
each patent’s citation count by the average citation count of all patents in the same
year and technology class. For each type of adjustment, I then sum up the adjusted
citation count across all patents applied for during each firm-year, and compute the
corresponding average number of adjusted citations per patent for each firm-year.
I merge the patent data with the executive compensation data. Following the
innovation literature, I set the patent count and citations-per-patent count to zero for
firms without available patent or citation information from the NBER patent database.
Due to the right skewness of the innovation measures in the final sample, I winsorize
these variables at the 99th percentiles.
2.2.2. Measuring incentives

ExecuComp provides executive compensation data from 1992, which I use to
construct my measures of CEO incentives. I define CEO total compensation as the
sum of the CEO’s annual total pay and changes in the value of the CEO’s portfolio of
stock and options (Jensen and Murphy, 1990; Hall and Liebman, 1998; Core, Guay
and Verrecchia, 2003; Edmans, Gabaix and Landier, 2009). Hall and Liebman (1998)
and Core, Guay and Verrecchia (2003), among others, document that CEO incentives
come almost entirely from changes in the value of CEO holdings of stock and options.
Thus, incentives stem from the CEO’s holdings of shares and options, which include
restricted and unrestricted stock, and unvested and vested options. For the purpose of
this study, I calculate an incentive measure separately for each source of equity-based
incentives. Specifically, I adopt the scaled wealth-performance sensitivity (the dollar
change in wealth for a percent change in firm value, scaled by annual total pay)
advocated by Edmans, Gabaix and Landier (2009) as the main incentive measure.3
I follow the methodology of Core and Guay (2002) and the detailed procedure
described in appendix B in Edmans, Gabaix and Landier (2009), where the delta
of an option is computed using the Black-Scholes model, to calculate the incentive
measures separately for unvested and vested options.4 I compute similar measures
for restricted and unrestricted stockholdings where each share has a delta of 1. Each
incentive measure indicates the change, expressed as a percentage of annual total
3 This empirical measure of incentives is generated from multiplicative specifications for the CEO’s utility
and production functions. The use of a multiplicative utility function is consistent with consumer theory
and macroeconomic labor models. The model’s predictions are consistent with a number of well-known
stylized facts regarding compensation. Further, by virtue of being independent of firm size, the scaled
wealth-performance sensitivity can be comparable across firms and over time.
4 Core and Guay (2002) and Edmans, Gabaix and Landier (2009) consider three categories of option
holdings: newly granted options (awarded during the current year), previously granted unexercisable op-
tions, and previously granted exercisable options. I follow their assumptions on how these three categories
contribute to the end-of-year total unvested options and total vested options; this procedure allows me to
utilize as much as possible the information available for newly granted options.
pay, in the CEO’s wealth that he/she receives from the corresponding equity-based
incentive source for a percent change in firm value.
The minimal holding periods for restricted stock and minimal vesting periods
for unvested options provide managers an incentive to take actions that increase
the long-term value of the firm. As such, unvested options and restricted stock can
be viewed as sources of long-term (unvested) incentives. On the other hand, the
liquidity restrictions have been lifted for vested options and unrestricted stock. As the
payoffs can be taken in the short term, vested options and unrestricted stock can be
viewed as sources of short-term (vested) incentives. For a comprehensive analysis,
I also construct summary incentive measures for the CEO’s total holdings of stock
and options; option holdings; stock holdings; restricted stock and unvested option
holdings (long-term/unvested); and unrestricted stock and vested option holdings
(short-term/vested). I winsorize the incentive measures at the 1st and 99th percentiles
to mitigate the effect of outliers.
In addition to the CEO’s incentive measures, I replicate the above procedure
to obtain incentive measures for the top four non-CEO executives whose ranking
is determined by the sum of salaries and bonuses. I then form firm-level average
executive incentive measures where each executive’s measures are weighted by the
fraction of his/her sum of salaries and bonuses across the top five executives including
CEO. In calculating my measures of incentives (wealth-performance sensitivity), I
deflate all nominal variables using the gross domestic product deflator from the
Bureau of Economic Analysis Web site.
To verify that my analysis is not sensitive to how I measure executive incentives,
in a robustness test, I also use a more traditional measure of CEO incentives—CEO
delta, calculated separately for each source of equity-based incentives.
2.2.3. Other explanatory variables

Following the innovation literature (see, e.g., Hirshleifer, Low and Teoh, 2012;
Atanassov, 2013; He and Tian, 2013; Fang, Tian and Tice, 2014; Sapra, Subrama-
nian and Subramanian, 2014), I include controls for firm size, firm age, return on
assets, leverage, asset tangibility, investment in intangible assets, capital expendi-
tures, growth opportunities, industry concentration and institutional ownership. Firm
size is proxied by the natural logarithm of sales. Firm age is approximated by the
number of years since the firm’s first being listed on COMPUSTAT. Asset tangibility
is proxied by net property, plant, and equipment (PPE) scaled by total assets. Invest-
ment in intangible assets is research and development expenditures scaled by total
assets. Following Sapra, Subramanian and Subramanian (2014), I use the industry-
average Tobin’s Q (calculated at the two-digit Standard Industrial Classification [SIC]
level) to control for growth opportunities.5 The relationship between innovation and
5 Sapra, Subramanian and Subramanian (2014) argue that firm-level Q is likely to be endogenously
determined along with firm-level innovation.
industry concentration is captured by a sales-based Herfindahl index (constructed at

the two-digit SIC level) and its square. All control variables are winsorized at the 1st
and 99th percentiles to remove the influence of extreme outliers. I provide detailed
descriptions of all variables in the Appendix.
2.3. Baseline specification

To assess how executive incentives affect innovation, I estimate the following
regression specification:
Innovation outputi ,t+1 = a + βIncentivesi,t + γ Xi,t + Yeart + Firmi

+ ei ,t+1 , (1)
where i indexes firm and t indexes time. The innovation output variables are the
natural logarithm of 1 plus the number of patents filed (and eventually granted) and
the natural logarithm of 1 plus the number of citations per patent. As discussed in
Section 2.2.1, I use two measures of patent count: a raw patent count and a patent
count adjusted for year effects; and four measures of citations-per-patent count: a
raw citations-per-patent count, a citations-per-patent count adjusted using the citation
truncation weight index, a citations-per-patent count adjusted for year effects, and a
citations-per-patent count adjusted for year and technology class effects. Incentives
(scaled wealth-performance sensitivity) is my main variable of interest and I assess
the incentive effects from the CEO’s holdings of unvested options, vested options,
restricted stock, and unrestricted stock separately. Xi,t is a vector of control variables as
discussed in Section 2.2.3. All independent variables are lagged by one year. I include
firm fixed effects to control for time-invariant unobservable firm characteristics, and
year fixed effects to control for economy-wide shocks. The inclusion of firm fixed
effects in particular helps mitigate the endogeneity issue caused by omitted variables
if the unobservable firm characteristics correlated with both executive incentives
and innovation output are constant over time. I cluster standard errors at the firm
level.
2.4. Descriptive statistics

Table 1 contains summary statistics of innovation variables (Panel A), incentive
measures (Panel B) and baseline control variables (Panel C) for the sample. On
average, a firm in this sample has 16.24 granted patents per year and each patent
receives 1.70 citations. The citations-per-patent counts adjusted using the weight
index, for year effects, for year and technology class effects are 4.13, 0.36, and 0.38,
respectively. With regard to the incentive measures, the median wealth-performance
sensitivity associated with the CEO’s total holdings of stock and options is 10.35,
quite close to Edmans, Gabaix and Landier’s (2009) figure of 9.04 for CEOs of
the 500 largest firms in 1999. The bulk of incentives appears to come from an
Table 1
Summary statistics
This table reports summary statistics of the main variables for the sample of firm-year observations from
1992 to 2006. See the Appendix for variable definitions.
Panel A: Innovation variables
Variable Observations Mean Median SD

No. of patents, raw (Patent) 13,279 16.24 0.00 75.92
No. of patents, year-adjusted (YPatent) 13,279 0.47 0.00 2.17
Citations per patent, raw (CitePat) 13,279 1.70 0.00 4.67
Citations per patent, index-adjusted (ICitePat) 13,279 4.13 0.00 9.80
Citations per patent, year-adjusted (YCitePat) 13,279 0.36 0.00 0.82
Citations per patent, 13,233 0.38 0.00 0.83
year-and-technology-class-adjusted
(YTCitePat)
Panel B: Incentives (wealth-performance sensitivity) variables

CEO
Incentives, total 13,279 52.74 10.35 159.41
Incentives, options 13,279 7.78 4.77 10.09
Incentives, stock 13,279 44.96 2.83 158.94
Incentives, restricted stock and unvested 13,279 3.05 1.96 4.00
options (long-term/unvested)
Incentives, unrestricted stock and vested 13,279 49.69 7.40 159.28
options (short-term/vested)
Incentives, unvested options 13,279 2.79 1.69 3.91
Incentives, vested options 13,279 4.99 2.57 7.68
Incentives, restricted stock 13,279 0.26 0.00 0.70
Incentives, unrestricted stock 13,279 44.70 2.40 158.97
Top five
Incentives, unvested options 13,003 2.47 1.69 2.70
Incentives, vested options 13,003 3.62 2.38 3.98
Incentives, restricted stock 13,003 0.22 0.00 0.50
Incentives, unrestricted stock 13,003 13.51 2.15 31.55
Panel C: Baseline control variables

Ln (Sales) 13,279 6.88 6.83 1.56
Firm age 13,279 22.68 18.00 15.45
ROA 13,279 0.14 0.15 0.12
Leverage 13,279 0.21 0.20 0.18
PPE/Assets 13,279 0.30 0.25 0.22
Research and development/Assets 13,279 0.04 0.00 0.07
Capital expenditures/Assets 13,279 0.07 0.05 0.06
MI Tobin’s Q 13,279 2.32 2.15 0.86
Herfindahl index 13,279 0.05 0.04 0.05
Institutional holdings 13,279 0.60 0.63 0.21
executive’s holdings of unrestricted stock. On average, the change in compensation,

as a percentage of annual total pay, that a CEO (top five executive) receives from
his/her unrestricted stock holdings is 44.70% (13.51%) for a 1% change in firm value.
The corresponding figures for unvested option holdings on the other hand are much
more modest, standing at 2.79% (2.47%).
3. Results
3.1. Baseline empirical results
Table 2 reports the results of estimating Equation (1). Innovation measures
are raw patent count and patent count adjusted for year effects in Panel A; raw
citations-per-patent count and citations-per-patent count adjusted using the citation
truncation weight index in Panel B; and citations-per-patent count adjusted for year
effects and citations-per-patent count adjusted for year and technology class effects
in Panel C. For each innovation measure, I estimate four specifications. First, I
look at the incentive effects from the CEO’s total holdings of stock and options.
Second, I decompose executive incentives into two separate measures based on
whether they are from stock holdings or from option holdings. Third, I separate
incentives into unvested or long-term (stemming from restricted stock and unvested
option holdings) and vested or short-term (stemming from unrestricted stock and
vested option holdings). And finally, I look at the incentive effects of each source
separately.
For all innovation measures, the total incentive measure has an insignificant
coefficient. The options-based incentive measure is positive and significant in the
patent regressions but insignificant in the citation regressions; the stock-based in-
centive measure, on the other hand, does not appear to be associated with the firm’s
innovation output in the following year, both in terms of quantity and quality. The di-
chotomy between vested (long-term) and unvested (short-term) incentives shows that
a higher level of executive unvested incentives is associated with not only a higher
number of patents but also a higher impact of patents generated in the following
year. And finally, the most detailed breakdown of incentive measures suggests that
this positive relation mainly comes from the CEO’s holdings of unvested options.
The evidence thus suggests that not all sources of equity-based incentives are equal
when it comes to motivating innovation. In particular, the findings are consistent
with my hypothesis that long-term incentives in the form of stock options with long
vesting periods motivate exploration and innovation. The results also suggest that
a traditional pay-for-performance sensitivity measure that lumps together all types
of equity-based compensation would likely fail to capture any motivating effect of
equity-based incentives on innovation.
Using the results in column 8 of Panel A, a one-standard-deviation increase in
executive incentives stemming from unvested option holdings increases the number
of year-adjusted patents in the following year by 2.0% of its mean. Likewise, the
Table 2
CEO incentives and corporate innovation
The table presents the results from regressions of innovation output on CEO incentives. The sample period is 1992–2006. The dependent variable is indicated by
the column heading. All independent variables are lagged by one year. Variable definitions are provided in the Appendix. All regressions include firm and year
fixed effects. Standard errors are heteroskedasticity-consistent and clustered at the firm level. The t-statistics are reported in parentheses.
Panel A: CEO incentives and patent counts, raw and year-adjusted
Ln (1 + Patent) Ln (1 + YPatent)
(1) (2) (3) (4) (5) (6) (7) (8)

Incentives, total 0.0001 0.0000
(1.06) (0.40)
Incentives, options 0.0026 0.0006
(2.76)*** (2.27)**
Incentives, stock 0.0001 0.0000
(0.65) (0.05)
Incentives, long-term 0.0085 0.0024
(3.74)*** (3.71)***
Incentives, short-term 0.0001 0.0000
(0.77) (0.08)
Incentives, unvested options 0.0076 0.0024
(2.87)*** (2.99)***
Incentives, vested options 0.0004 −0.0002
(0.30) (0.36)
T. Nguyen/The Financial Review 53 (2018) 255–300
Incentives, restricted stock 0.0236 0.0063

(1.36) (1.34)
Incentives, unrestricted stock 0.0001 0.0000
(0.75) (0.16)
Ln (Sales) 0.1968 0.1944 0.1960 0.1955 0.0662 0.0656 0.0659 0.0660
(5.80)*** (5.76)*** (5.80)*** (5.78)*** (5.41)*** (5.38)*** (5.41)*** (5.42)***
(Continued)
265
Table 2 (Continued) 266
Panel A: CEO incentives and patent counts, raw and year-adjusted
Ln (1 + Patent) Ln (1 + YPatent)
(1) (2) (3) (4) (5) (6) (7) (8)

Ln (1 + Firm age) 0.2152 0.2139 0.2209 0.2200 0.0830 0.0827 0.0846 0.0848
(2.75)*** (2.74)*** (2.83)*** (2.82)*** (2.99)*** (2.98)*** (3.04)*** (3.05)***
ROA −0.1503 −0.1576 −0.1758 −0.1754 −0.1110 −0.1127 −0.1184 −0.1188
(1.10) (1.15) (1.28) (1.27) (2.66)*** (2.71)*** (2.83)*** (2.83)***
Leverage −0.2880 −0.2825 −0.2829 −0.2802 −0.0577 −0.0564 −0.0562 −0.0559
(2.93)*** (2.88)*** (2.88)*** (2.86)*** (2.14)** (2.10)** (2.09)** (2.08)**
PPE/Assets 0.4955 0.4982 0.5014 0.4991 0.1499 0.1505 0.1515 0.1510
(3.09)*** (3.11)*** (3.13)*** (3.11)*** (3.01)*** (3.02)*** (3.04)*** (3.03)***
Hindex 3.9303 3.9038 3.9652 3.9670 0.9693 0.9631 0.9793 0.9840
(3.20)*** (3.19)*** (3.23)*** (3.23)*** (3.24)*** (3.23)*** (3.28)*** (3.29)***
Hindex squared −6.9572 −6.8726 −6.9453 −6.9466 −1.8431 −1.8232 −1.8397 −1.8475
(2.63)*** (2.60)*** (2.61)*** (2.61)*** (2.94)*** (2.91)*** (2.93)*** (2.94)***
Research and development/Assets 1.3692 1.3559 1.3476 1.3488 0.3379 0.3347 0.3317 0.3322
(3.64)*** (3.62)*** (3.58)*** (3.59)*** (2.68)*** (2.66)*** (2.64)*** (2.64)***
Capital expenditures/Assets −0.0613 −0.0715 −0.0796 −0.0794 0.0097 0.0073 0.0044 0.0046
(0.34) (0.39) (0.44) (0.43) (0.19) (0.15) (0.09) (0.09)
MI Tobin’s Q 0.0142 0.0121 0.0104 0.0105 −0.0060 −0.0065 −0.0071 −0.0071
(0.76) (0.65) (0.56) (0.57) (1.24) (1.33) (1.46) (1.45)

Institutional holdings 0.1602 0.1546 0.1492 0.1487 0.0402 0.0389 0.0371 0.0370
(2.39)** (2.31)** (2.23)** (2.23)** (2.20)** (2.12)** (2.03)** (2.03)**
R2 0.2741 0.2749 0.2755 0.2756 0.1460 0.1466 0.1477 0.1479
Observations 13,279 13,279 13,279 13,279 13,279 13,279 13,279 13,279
(Continued)
Table 2 (Continued)
Panel B: CEO incentives and citations-per-patent counts, raw and index-adjusted
Ln (1 + CitePat) Ln (1 + ICitePat)
(1) (2) (3) (4) (5) (6) (7) (8)

Incentives, total −0.0001 −0.0001
(0.96) (0.66)
(1.43) (1.58)
Incentives, stock −0.0001 −0.0001
(1.21) (0.94)
(2.52)** (2.64)***
Incentives, short-term −0.0001 −0.0001
(1.18) (0.91)
(1.83)* (2.00)**
Incentives, vested options −0.0002 −0.0002
(0.13) (0.12)
(1.73)* (1.54)
Incentives, unrestricted stock −0.0001 −0.0001
(1.13) (0.86)
Ln (Sales) 0.0655 0.0641 0.0649 0.0648 0.1005 0.0986 0.0997 0.0996
(1.99)** (1.95)* (1.98)** (1.98)** (2.64)*** (2.59)*** (2.63)*** (2.62)***
Ln (1 + Firm age) 0.0704 0.0697 0.0740 0.0739 0.0180 0.0170 0.0229 0.0228
(0.89) (0.88) (0.94) (0.94) (0.19) (0.18) (0.24) (0.24)
(Continued)
267
268
Table 2 (Continued)
Panel B: CEO incentives and citations-per-patent counts, raw and index-adjusted
Ln (1 + CitePat) Ln (1 + ICitePat)
(1) (2) (3) (4) (5) (6) (7) (8)

ROA 0.5432 0.5392 0.5269 0.5263 0.4696 0.4640 0.4473 0.4466
(3.77)*** (3.75)*** (3.66)*** (3.66)*** (2.63)*** (2.60)*** (2.50)** (2.50)**
Leverage −0.1019 −0.0988 −0.0986 −0.0959 −0.1890 −0.1848 −0.1846 −0.1819
(1.13) (1.09) (1.09) (1.06) (1.64) (1.60) (1.60) (1.58)
PPE/Assets 0.5130 0.5145 0.5167 0.5141 0.5763 0.5784 0.5814 0.5787
(2.98)*** (2.99)*** (3.00)*** (2.98)*** (2.86)*** (2.87)*** (2.89)*** (2.87)***
Hindex 4.6897 4.6750 4.7121 4.7234 5.7604 5.7400 5.7909 5.8031
(3.01)*** (3.00)*** (3.03)*** (3.03)*** (3.24)*** (3.23)*** (3.26)*** (3.27)***
Hindex squared −9.2466 −9.1997 −9.2389 −9.2567 −10.7907 −10.7255 −10.7803 −10.7996
(2.79)*** (2.78)*** (2.79)*** (2.80)*** (2.99)*** (2.97)*** (2.99)*** (2.99)***
(3.62)*** (3.61)*** (3.59)*** (3.58)*** (3.15)*** (3.13)*** (3.11)*** (3.11)***
Capital expenditures/Assets −0.1555 −0.1612 −0.1672 −0.1668 −0.1606 −0.1685 −0.1766 −0.1762
(0.76) (0.79) (0.82) (0.82) (0.60) (0.63) (0.66) (0.66)
MI Tobin’s Q −0.0782 −0.0793 −0.0806 −0.0804 −0.0392 −0.0408 −0.0425 −0.0423
(3.95)*** (4.00)*** (4.07)*** (4.06)*** (1.55) (1.62) (1.69)* (1.68)*
Institutional holdings 0.0669 0.0638 0.0598 0.0593 0.0704 0.0661 0.0607 0.0602
(0.99) (0.95) (0.89) (0.88) (0.82) (0.77) (0.71) (0.71)
R2 0.3461 0.3464 0.3468 0.3470 0.2934 0.2937 0.2941 0.2942
Observations 13,279 13,279 13,279 13,279 13,279 13,279 13,279 13,279
(Continued)
Table 2 (Continued)
Panel C: CEO incentives and citations-per-patent counts, year-adjusted and year-and-technology-class-adjusted
Ln (1 + YCitePat) Ln (1 + YTCitePat)
(1) (2) (3) (4) (5) (6) (7) (8)

Incentives, total −0.0000 −0.0000
(0.43) (0.31)
(1.16) (1.14)
Incentives, stock −0.0000 −0.0000
(0.62) (0.51)
(2.63)*** (2.69)***
Incentives, short-term −0.0000 −0.0000
(0.65) (0.55)
(2.35)** (2.45)**
Incentives, vested options −0.0004 −0.0005
(0.65) (0.68)
(0.65) (0.63)
Incentives, unrestricted stock −0.0000 −0.0000
(0.54) (0.42)
(Continued)
269
Table 2 (Continued)
270
Panel C: CEO incentives and citations-per-patent counts, year-adjusted and year-and-technology-class-adjusted
Ln (1+YCitePat) Ln (1 + YTCitePat)
(1) (2) (3) (4) (5) (6) (7) (8)

Ln (Sales) 0.0104 0.0100 0.0102 0.0105 0.0094 0.0090 0.0092 0.0095
(0.84) (0.80) (0.82) (0.85) (0.74) (0.71) (0.73) (0.75)
Ln (1 + Firm age) −0.0540 −0.0543 −0.0524 −0.0517 −0.0243 −0.0245 −0.0227 −0.0220
(1.79)* (1.80)* (1.74)* (1.72)* (0.78) (0.79) (0.73) (0.71)
ROA 0.1131 0.1117 0.1057 0.1048 0.0861 0.0848 0.0789 0.0779
(1.61) (1.59) (1.51) (1.49) (1.27) (1.26) (1.17) (1.15)
Leverage −0.0166 −0.0156 −0.0152 −0.0156 −0.0366 −0.0356 −0.0352 −0.0356
(0.44) (0.41) (0.40) (0.41) (0.94) (0.92) (0.90) (0.92)
PPE/Assets 0.1019 0.1024 0.1035 0.1035 0.0825 0.0830 0.0842 0.0842
(1.67)* (1.68)* (1.69)* (1.69)* (1.33) (1.34) (1.36) (1.36)
Hindex 1.8172 1.8120 1.8273 1.8348 1.2872 1.2826 1.2982 1.3058
(3.76)*** (3.76)*** (3.80)*** (3.80)*** (2.61)*** (2.61)*** (2.64)*** (2.65)***
Hindex squared −3.4291 −3.4128 −3.4257 −3.4389 −2.4116 −2.3966 −2.4101 −2.4237
(3.71)*** (3.69)*** (3.72)*** (3.73)*** (2.55)** (2.53)** (2.56)** (2.57)**
(1.59) (1.57) (1.55) (1.55) (0.89) (0.87) (0.85) (0.85)
Capital expenditures/Assets −0.0009 −0.0028 −0.0062 −0.0060 −0.0216 −0.0235 −0.0267 −0.0266
(0.01) (0.03) (0.07) (0.07) (0.23) (0.25) (0.29) (0.28)
MI Tobin’s Q −0.0124 −0.0128 −0.0135 −0.0135 −0.0067 −0.0071 −0.0078 −0.0077

(1.49) (1.53) (1.62) (1.62) (0.78) (0.82) (0.90) (0.90)
Institutional holdings 0.0021 0.0010 −0.0011 −0.0011 0.0030 0.0019 −0.0002 −0.0002
(0.07) (0.04) (0.04) (0.04) (0.10) (0.07) (0.01) (0.01)
R2 0.1465 0.1466 0.1472 0.1472 0.1396 0.1397 0.1403 0.1403
Observations 13,279 13,279 13,279 13,279 13,233 13,233 13,233 13,233
***, **, * indicate statistical significance at the 0.01, 0.05 and 0.10 level, respectively.
results in column 4 of Panel C implies that a one-standard-deviation increase in

executive incentives stemming from unvested option holdings increases the number
of year-adjusted citations per patent in the following year by 2.9% of its mean.
In untabulated analysis, I estimate Equation (1) replacing firm fixed effects with
industry fixed effects, where industries are classified at the two-digit SIC level. In
the cross-section of firms, it appears that both sources of long-term incentives—
unvested option holdings and restricted stock holdings are positively associated with
subsequent innovation output. However, as reported in Table 2, a within-firm variation
in CEO incentives associated with restricted stock holdings does not appear to be
related to the firm’s subsequent variation in innovation output.
3.2. Industry innovativeness

Innovation potentials vary across industries, hence the innovation-motivating
impact of incentive measures could as well differ. I expect the effect of long-term in-
centives in the form of unvested options on innovation to be stronger in industries with
good opportunities for innovation. Or put it differently, I expect that firms operating
in industries where substantial opportunities for innovation are available recognize
the importance of long-term incentives in motivating exploration and innovation and
therefore use these incentives to that effect. This hypothesis is also consistent with
Gopalan, Milbourn, Song and Thakor’s (2014) documented results that CEO pay
duration is longer in firms with more growth opportunities, measured by the firm’s
current market-to-book ratio, and firms with greater research and development in-
tensity, measured by current research and development expenditures scaled by total
assets.
Following Hirshleifer, Low and Teoh (2012), I partition the sample into inno-
vative industries and noninnovative industries. I define an industry as innovative if
the average number of year-adjusted citations per patent for the industry during the
preceding year is greater than the median average year-adjusted citations-per-patent
count across all industries, where industries are classified at the two-digit SIC level.6
The univariate test results reported in Panel A of Table 3 show how different innova-
tive industries and noninnovative industries are with regard to executive incentives.
While the total incentives are not statistically significantly different between the two
groups of firms, the composition of incentives differ in many aspects. Consistent with
my hypothesis, firms in innovative industries report higher total long-term incentives
and long-term incentives that stem from unvested option holdings. These firms also
have higher options-based incentives overall. Firms in noninnovative industries, on the
other hand, have higher long-term incentives that come from restricted stock holdings.
6 The main results are robust if I rely instead on the citations-per-patent count adjusted using the citation
truncation weight index or the citations-per-patent count adjusted for year and technology class effects to
define innovative industries. The results also hold qualitatively if I classify industries at the four-digit SIC
level instead.
Table 3
272
Industry innovativeness
In the table, firm-year observations are classified based on whether they belong to an innovative industry (Hi) or not (Lo). An industry is defined as innovative if
the average number of YCitePat for the industry during the preceding year is greater than the median average YCitePat across all industries. The sample period is
1992–2006. Panel A presents summary statistics of the Hi and Lo subsamples on industry innovativeness and the results of the t-tests for differences between the
means of the two subsamples. Panels B1 and B2 present the results from regressions of innovation output on CEO incentives. The dependent variable is indicated
by the column heading. The unreported control variables are Ln (Sales), Ln (1 + Firm age), ROA, Leverage, PPE/Assets, Hindex, Hindex squared, Research and
development/Assets, Capital expenditures/Assets, MI Tobin’s Q, and Institutional holdings. All independent variables are lagged by one year. Variable definitions
are provided in the Appendix. All regressions include firm and year fixed effects. Standard errors are heteroskedasticity-consistent and clustered at the firm level.
The t-statistics are reported in parentheses.
Panel A: Summary statistics of Hi and Lo subsamples on industry innovativeness
Innovation measures
Hi Lo Mean test (Hi vs Lo)
Variable Observations Mean Median SD Observations Mean Median SD p-Value

Patent 8,012 25.11 1.00 93.53 5,267 2.76 0.00 30.40 0.0000
YPatent 8,012 0.73 0.02 2.66 5,267 0.09 0.00 0.94 0.0000
CitePat 8,012 2.48 0.00 5.39 5,267 0.52 0.00 2.92 0.0000
ICitePat 8,012 6.01 0.00 11.12 5,267 1.26 0.00 6.39 0.0000
YCitePat 8,012 0.54 0.00 0.93 5,267 0.10 0.00 0.50 0.0000
YTCitePat 7,984 0.56 0.00 0.94 5,249 0.11 0.00 0.52 0.0000
Incentives measures

Incentives, total 8,012 51.25 10.11 159.97 5,267 55.02 10.84 158.55 0.1831
Incentives, options 8,012 7.99 4.86 10.38 5,267 7.46 4.62 9.63 0.0029
(Continued)
Table 3 (Continued)
Panel A: Summary statistics of Hi and Lo subsamples on industry innovativeness
Incentives measures

Incentives, stock 8,012 43.26 2.71 159.09 5,267 47.56 3.06 158.69 0.1274
Incentives, long-term/unvested 8,012 3.14 2.03 4.08 5,267 2.92 1.88 3.85 0.0014
Incentives, short-term/vested 8,012 48.11 7.17 159.71 5,267 52.10 7.75 158.62 0.1578
Incentives, unvested options 8,012 2.89 1.76 4.00 5,267 2.64 1.58 3.77 0.0003
Incentives, vested options 8,012 5.10 2.65 7.81 5,267 4.82 2.46 7.46 0.0376
Incentives, restricted stock 8,012 0.25 0.00 0.70 5,267 0.28 0.00 0.71 0.0576
Incentives, unrestricted stock 8,012 43.01 2.34 159.12 5,267 47.28 2.56 158.72 0.1296
Panel B1: CEO incentives and corporate innovation—long-term versus short-term incentives
Ln (1 + YPatent) Ln (1 + ICitePat) Ln (1 + YCitePat) Ln (1 + YTCitePat)
Hi Lo Hi Lo Hi Lo Hi Lo
(1) (2) (3) (4) (5) (6) (7) (8)
Incentives, long-term 0.0034 0.0006 0.0092 −0.0016 0.0034 −0.0007 0.0033 −0.0002
(3.79)*** (1.33) (2.66)*** (0.56) (2.65)*** (0.77) (2.58)*** (0.22)
Incentives, short-term −0.0000 0.0000 −0.0002 0.0002 −0.0001 0.0001 −0.0001 0.0001
(0.34) (1.59) (1.43) (1.30) (1.51) (1.70)* (1.48) (1.63)
Controls Yes Yes Yes Yes Yes Yes Yes Yes
R2 0.2069 0.0352 0.4060 0.0936 0.2020 0.0504 0.1916 0.0511
Observations 8,012 5,267 8,012 5,267 8,012 5,267 7,984 5,249
(Continued)
273
274
Table 3 (Continued)
Panel B2: CEO incentives and corporate innovation—breakdown of incentives
(1) (2) (3) (4) (5) (6) (7) (8)
Incentives, unvested options 0.0039 0.0003 0.0096 −0.0018 0.0040 −0.0007 0.0039 −0.0000
(3.40)*** (0.58) (2.29)** (0.52) (2.50)** (0.56) (2.46)** (0.04)
Incentives, vested options −0.0006 0.0004 −0.0003 0.0001 −0.0005 −0.0001 −0.0005 −0.0002
(0.98) (1.02) (0.12) (0.06) (0.51) (0.13) (0.53) (0.23)
Incentives, restricted stock 0.0032 0.0027 0.0005 0.0045 −0.0031 0.0015 −0.0023 0.0003
(0.47) (1.29) (0.02) (0.21) (0.38) (0.26) (0.28) (0.05)
Incentives, unrestricted stock −0.0000 0.0000 −0.0002 0.0002 −0.0001 0.0001 −0.0001 0.0001
(0.15) (1.39) (1.44) (1.29) (1.45) (1.70)* (1.40) (1.63)
R2 0.2071 0.0361 0.4060 0.0937 0.2022 0.0505 0.1918 0.0512
Observations 8,012 5,267 8,012 5,267 8,012 5,267 7,984 5,249
To conserve space, in Panel B of Table 3, I omit the regression results for the
raw patent count and raw citations-per-patent count. The results show unambiguously
that long-term incentives (Panel B1), in particular, unvested options-based incentives
(Panel B2), are associated with greater innovation only within innovative indus-
tries. Within innovative industries, the effect of unvested options-based incentives is
larger in magnitude than in the previous test that pools together all industries. For
example, a one-standard-deviation increase in the incentive measure increases the
number of year-adjusted patents in the following year by 3.3% of its mean, and the
number of year-adjusted citations per patent in the following year by 4.4% of its
mean.7
Overall, the results of the univariate test and regression analysis combined sug-
gest that incentive practices that arguably inspire exploration and innovation are used
more extensively among firms in innovative industries, and more importantly, that
these firms appear to benefit from the adoption of innovation-motivating incentive
practices. These results are thus consistent with the conjecture that long-term exec-
utive incentives exhibit their strongest effect where opportunities for innovation are
abundant.
Within noninnovative industries, long-term incentives in general and unvested
options-based incentives in particular do not appear to be related to subsequent
innovation outcomes. There is some evidence that unrestricted stock-based incentives
are associated with a higher impact of patents, however, the effect is statistically
marginal and economically negligible.
Overall, these results go further than Gopalan, Milbourn, Song and Thakor’s
(2014) implication to suggest that the adoption of innovation-motivating incentive
practices in innovative firms are associated with increased output measures of suc-
cessful innovation in the next period, both quantitatively and qualitatively, as opposed
to the CEO’s total pay duration being longer for firms with higher concurrent research
and development expenditures, which represent one of several inputs to innovation.
And more importantly, I show that, specifically, it is the long-term incentives that
stem from the CEO’s holdings of unvested options that motivate exploration and
innovation.
3.3. Product market competition

Strong product market competition puts pressure on a firm to fight for survival
by seeking to achieve and maintain competitive advantages over its rivals. I therefore
expect long-term incentives in general and unvested options-based incentives in
particular to have a stronger effect in a more competitive product market, where the
7 These figures are obtained using the sample summary statistics to provide a direct comparison with those
obtained in Section 3.1. Using summary statistics for innovative industries, the corresponding figures are
2.2% and 3.0%, also greater than those reported in Section 3.1 for the whole sample.
needs for exploration and innovation to develop a source of sustained competitive

advantage might be perceived as more important and urgent.
To test this conjecture, I split the sample at the median Herfindahl index.8 An
observation is considered to be in a highly competitive product market if it belongs
to an industry with a Herfindahl index below the sample median. Panel A of Table 4
reports the univariate test results for the high and low subsamples on product market
competition. The two subsamples are remarkably different in terms of innovation
outcomes. Firms in more competitive product markets significantly outperform those
in less competitive product markets by all measures of innovation. This is consistent
with the conjecture that innovation is more important for firms operating in a more
competitive product market. Furthermore, these stark differences in firms’ innovation
are accompanied by significant differences with respect to their executive incentives’
composition. While the total incentives are not statistically significantly different
between the two subsamples, firms in more competitive product markets have higher
options-based incentives, and in line with my prediction, significantly higher total
long-term incentives and unvested options-based long-term incentives.
Regression results reported in Panel B of Table 4 corroborate these initial find-
ings. Only for the high subsample on product market competition, I find that total
long-term incentives (Panel B1), in particular, unvested options-based long-term in-
centives (Panel B2), are associated with greater innovation. Using summary statistics
for the high subsample and regression coefficients in Panel B2, a one-standard-
deviation increase in the unvested options-based incentives increases the number of
year-adjusted patents in the following year by 1.8% of its mean, and the number of
year-adjusted citations per patent in the following year by 3.1% of its mean. Such
effect is totally absent for the low subsample on product market competition.
Overall, the results suggest that firms for which innovation is more important
due to strong competitive pressure appear to adopt incentive practices that supposedly
motivate exploration and innovation and these incentive practices, in turn, appear to
exert the desirable effect on firm innovation.
3.4. Robustness checks

Taken together, the results from the baseline regressions and cross-sectional
analyses provide support for the empirical implications of Manso (2011) regarding
executive compensation and motivating innovation. In this section, I perform several
tests to examine if the preceding results are robust to alternative measures of executive
incentives and different model specifications. To conserve space, for a number of
8 Following Kim and Lu (2011), I use the median of all firm-year observations rather than the median across
industries to obtain more balanced subsamples of high and low product market competition. Because there
are significantly more firms in low concentration industries, using the cross-industry median would result
in significantly unbalanced subsamples.
Table 4
Product market competition
In the table, firm-year observations are classified based on whether they are in a highly competitive product market (Hi) or not (Lo). An observation is considered
to be in a highly competitive product market if it belongs to an industry with a Herfindahl index below the sample median. The sample period is 1992–2006.
Panel A presents summary statistics of the Hi and Lo subsamples on product market competition and the results of the t-tests for differences between the means
of the two subsamples. Panels B1 and B2 present the results from regressions of innovation output on CEO incentives. The dependent variable is indicated by
the column heading. The unreported control variables are Ln (Sales), Ln (1 + Firm age), ROA, Leverage, PPE/Assets, Hindex, Hindex squared, Research and
development/Assets, Capital expenditures/Assets, MI Tobin’s Q, and Institutional holdings. All independent variables are lagged by one year. Variable definitions
are provided in the Appendix. All regressions include firm and year fixed effects. Standard errors are heteroskedasticity-consistent and clustered at the firm level.
The t-statistics are reported in parentheses.
Panel A: Summary statistics of Hi and Lo subsamples on product market competition
Innovation measures

Patent 6,777 24.38 0.00 93.63 6,502 7.76 0.00 49.94 0.0000
YPatent 6,777 0.71 0.00 2.66 6,502 0.23 0.00 1.47 0.0000
CitePat 6,777 1.99 0.00 4.76 6,502 1.40 0.00 4.55 0.0000
ICitePat 6,777 5.18 0.00 10.45 6,502 3.03 0.00 8.96 0.0000
YCitePat 6,777 0.47 0.00 0.90 6,502 0.25 0.00 0.71 0.0000
YTCitePat 6,748 0.48 0.00 0.89 6,485 0.28 0.00 0.76 0.0000
Incentives measures

Incentives, total 6,777 53.12 10.29 166.36 6,502 52.35 10.42 151.83 0.7812
Incentives, options 6,777 8.44 5.10 10.88 6,502 7.09 4.40 9.15 0.0000
(Continued)
277
Table 4 (Continued) 278
Panel A: Summary statistics of Hi and Lo subsamples on product market competition
Incentives measures

Incentives, stock 6,777 44.68 2.60 165.52 6,502 45.26 3.10 151.79 0.8340
Incentives, long-term/unvested 6,777 3.34 2.17 4.24 6,502 2.75 1.77 3.70 0.0000
Incentives, short-term/vested 6,777 49.78 7.16 166.12 6,502 49.60 7.65 151.84 0.9507
Incentives, unvested options 6,777 3.08 1.86 4.19 6,502 2.48 1.49 3.58 0.0000
Incentives, vested options 6,777 5.36 2.79 8.17 6,502 4.61 2.38 7.10 0.0000
Incentives, restricted stock 6,777 0.27 0.00 0.71 6,502 0.26 0.00 0.70 0.8371
Incentives, unrestricted stock 6,777 44.42 2.20 165.52 6,502 45.00 2.66 151.85 0.8333
Panel B1: CEO incentives and corporate innovation—long-term versus short-term incentives
(1) (2) (3) (4) (5) (6) (7) (8)
Incentives, long-term 0.0034 0.0011 0.0081 0.0003 0.0037 −0.0004 0.0032 0.0000
(3.45)*** (1.02) (2.16)** (0.10) (2.66)*** (0.35) (2.49)** (0.03)
Incentives, short-term −0.0000 0.0000 −0.0001 0.0001 −0.0001 0.0001 −0.0000 0.0000
(0.64) (1.08) (0.94) (0.53) (1.18) (1.07) (0.87) (0.86)
R2 0.2148 0.0883 0.3919 0.1955 0.1945 0.1021 0.1866 0.0986
Observations 6,777 6,502 6,777 6,502 6,777 6,502 6,748 6,485
(Continued)
Table 4 (Continued)
Panel B2: CEO incentives and corporate innovation—breakdown of incentives
(1) (2) (3) (4) (5) (6) (7) (8)
Incentives, unvested options 0.0031 0.0015 0.0067 −0.0001 0.0034 0.0000 0.0031 0.0004
(2.61)*** (1.08) (1.54) (0.03) (2.15)** (0.02) (2.09)** (0.26)
Incentives, vested options −0.0001 −0.0001 0.0005 0.0002 −0.0000 −0.0004 −0.0001 −0.0004
(0.11) (0.28) (0.24) (0.08) (0.03) (0.42) (0.17) (0.37)
Incentives, restricted stock 0.0161 −0.0046 0.0365 0.0080 0.0114 −0.0033 0.0089 −0.0017
(1.99)** (0.99) (1.61) (0.37) (1.41) (0.45) (1.10) (0.23)
Incentives, unrestricted stock −0.0000 0.0000 −0.0002 0.0001 −0.0001 0.0001 −0.0000 0.0000
(0.64) (0.99) (1.00) (0.53) (1.18) (1.12) (0.85) (0.91)
R2 0.2156 0.0889 0.3922 0.1955 0.1947 0.1023 0.1867 0.0987
Observations 6,777 6,502 6,777 6,502 6,777 6,502 6,748 6,485
279
robustness tests, I include a discussion but do not tabulate the results. These results
are available from the author on request.
3.4.1. Alternative measures of incentives

As discussed in Section 2.2.2, I follow the methodology of Core and Guay (2002)
and Edmans, Gabaix and Landier (2009) to calculate my executive incentive mea-
sures. In particular, I follow closely their assumptions on how the three categories of
option holdings (newly granted options, previously granted unexercisable options, and
previously granted exercisable options) contribute to the end-of-year total unvested
options and total vested options in order to utilize as much as possible the detailed
information available for newly granted options. When such a contribution is not clear
cut,9 my alternative calculation is based directly on the end-of-year total unvested op-
tions and total vested options. The findings, however, are not sensitive to this practice.
I also verify that the results are not driven by the adoption of the scaled
wealth-performance sensitivity as my main incentive measure. In an untabulated
robustness check, I use a more traditional measure of CEO incentives—CEO delta,
calculated separately for each source of equity-based incentives, and add CEO vega
as an additional control variable to the baseline regression specification. The main
results continue to hold.
In the baseline regressions, I focus on CEO incentives because of the important
role of the CEO in shaping corporate policies. To account for the overall influence
of top executives, I estimate Equation (1) using the top five executives’ incentives in
place of CEO incentives. The main results are robust with this firm-level average ex-
ecutive incentive measure. The findings thus suggest that the innovation-motivating
effects of unvested options-based incentives can be generalized to the top five
executives.
3.4.2. Corporate governance

Executive incentive compensation is one of the most important governance
mechanisms. Different governance attributes are used in tandem to address agency
problems. Following the innovation literature, my base specification includes in-
stitutional holdings to control for external governance; however, it is possible that
executive incentive compensation simply picks up the effect of other internal gov-
ernance attributes not included in the regression. Table 5 presents the results from
9 This is referred to as the final case in appendix B in Edmans, Gabaix and Landier (2009) where a portion
of the newly granted options are assumed to be exercisable. Since a CEO may receive multiple grants
with different terms in each year, it is not straightforward to determine which of the newly granted options
contribute toward the end-of-year total vested options.
Table 5
Controlling for other governance mechanisms
The table presents the results from regressions of innovation output on CEO incentives. The sample period is 1992–2006. The dependent variable is indicated
by the column heading. Gindex is the Gompers, Ishii, and Metrick (2003) governance index; Board independence is the percentage of the board of directors
that are independent; CEO-Chairman is a dummy variable equal to 1 if the CEO is also the chairman of the board; CEO tenure is the number of years as CEO;
and CEO vega is the dollar change in a CEO’s option holdings for a 1% change in stock return volatility. For each additional governance control variable,
missing observations are set to zero and a dummy variable indicating whether the governance data are available is included in the regression. Coefficients on
these dummy variables are not reported. The other unreported control variables are Ln (Sales), Ln (1 + Firm age), ROA, Leverage, PPE/Assets, Hindex, Hindex
squared, Research and development/Assets, Capital expenditures/Assets, MI Tobin’s Q, and Institutional holdings. All independent variables are lagged by one
year. See the Appendix for definitions of all other variables. All regressions include firm and year fixed effects. Standard errors are heteroskedasticity-consistent
and clustered at the firm level. The t-statistics are reported in parentheses.
Ln Ln Ln Ln Ln Ln Ln Ln
(1 + YPatent) (1 + YCitePat) (1 + YPatent) (1 + YCitePat) (1 + YPatent) (1 + YCitePat) (1 + YPatent) (1 + YCitePat)
(1) (2) (3) (4) (5) (6) (7) (8)
Incentives, unvested options 0.0024 0.0027 0.0025 0.0027 0.0024 0.0027 0.0025 0.0028
(3.01)*** (2.34)** (3.15)*** (2.37)** (3.05)*** (2.30)** (3.24)*** (2.35)**
Incentives, vested options −0.0002 −0.0005 −0.0003 −0.0006 −0.0002 −0.0004 −0.0003 −0.0006
(0.44) (0.75) (0.77) (0.88) (0.36) (0.65) (0.77) (0.88)
Incentives, restricted stock 0.0063 0.0036 0.0063 0.0036 0.0063 0.0035 0.0062 0.0035
(1.35) (0.66) (1.34) (0.66) (1.35) (0.64) (1.33) (0.64)
Incentives, unrestricted stock 0.0000 −0.0000 −0.0000 −0.0000 0.0000 −0.0000 −0.0000 −0.0000
(0.19) (0.50) (0.01) (0.53) (0.16) (0.55) (0.05) (0.56)
Gindex 0.0049 0.0097 0.0046 0.0098 0.0046 0.0099
(1.64) (2.66)*** (1.53) (2.69)*** (1.53) (2.69)***
Board independence −0.0174 −0.0314 −0.0173 −0.0312
(0.71) (1.01) (0.70) (1.01)
CEO-Chairman 0.0212 −0.0020 0.0213 −0.0020
(3.00)*** (0.21) (3.01)*** (0.20)

Ln (1 + CEO tenure) 0.0054 0.0047 0.0054 0.0047
(1.26) (0.86) (1.26) (0.86)
Ln (1 + CEO vega) 0.0000 −0.0003 −0.0004 −0.0007
(0.00) (0.10) (0.13) (0.21)
R2 0.1489 0.1482 0.1511 0.1486 0.1479 0.1472 0.1511 0.1486
Observations 13,279 13,279 13,279 13,279 13,279 13,279 13,279 13,279
281
estimating extended specifications that control for various governance attributes,

including overall quality of firm-level governance, board and CEO characteristics.10
As shown in Table 5, the coefficients on the additional governance controls,
when they are statistically significant, appear to suggest that a higher level of manage-
rial entrenchment, as measured by a higher number of antitakeover provisions (higher
Gompers, Ishii and Metrick, 2003 governance index) and dual role of CEO as top
manager and board chairman, is associated with more innovation. This evidence,
though quite limited, is consistent with Manso’s (2011) model implications. But
more importantly, the main results are robust to the inclusion of the additional
governance controls.
The positive relation between the number of antitakeover provisions and firm
innovation output documented in Table 5 is in line with the results in Chemmanur and
Tian (2017). Chemmanur and Tian (2017) interpret the evidence as suggesting that
antitakeover provisions allow managers to focus on long-term value creation, through
productive activities such as innovation, by insulating them from short-term pressures
exerted by public equity markets. A naturally arising question is how heterogeneity in
firms’ degree of exposure to the market for corporate control, which firms can change
by adding/dropping antitakeover provisions, affects the effect of executive incentives
on innovation. It could be argued that more exposure to (less insulation from) the
market for corporate control would necessitate firms’ use of governance mechanisms
such as executive compensation to counteract the short-term pressures from the equity
markets and provide managers with the incentives to pursue innovation; therefore,
one would likely observe a stronger effect of executive incentives on innovation.
In other words, the adoption of antitakeover provisions and the design of executive
incentive compensation can be seen as substitutes when firms choose their corporate
governance structure to motivate exploration and innovation. I therefore split the
sample to separately test the effect of executive incentive compensation conditioning
on a firm’s degree of insulation from the market for corporate control. An observation
belongs to the high subsample, with more insulation from (less exposure to) the market
for corporate control, if the number of antitakeover provisions in the firm’s Gompers,
Ishii and Metrick (2003) governance index (Gindex) is above the sample median.
Regression results reported in Table 6 are supportive of the conjecture. Firms
that are more exposed to the threat of hostile takeovers appear to rely on incentive
practices to motivate their managers to undertake innovation projects.
3.4.3. Managerial influence over compensation terms

Next, I address the concern that managers might have influence over the terms
of their own compensation, through such practices as timing or backdating their
10 In this robustness check, I follow the approach described in Kim and Lu (2011) to maintain sample size.
Specifically, for each additional governance control, I set missing observations to zero and include in the
regression a dummy variable equal to 1 if the governance data are available; this dummy variable allows
the intercept term to capture the mean of the governance variable for missing values.
Table 6
Insulation from the market for corporate control
In the table, firm-year observations are classified based on a firm’s degree of insulation from the market for corporate control. An observation belongs to the Hi
subsample (with more insulation from (less exposure to) the market for corporate control) if the number of antitakeover provisions in the firm’s Gindex is above
the sample median. The table presents the results from regressions of innovation output on CEO incentives. The sample period is 1992–2006. The dependent
variable is indicated by the column heading. The unreported control variables are Ln (Sales), Ln (1 + Firm age), ROA, Leverage, PPE/Assets, Hindex, Hindex
squared, Research and development/Assets, Capital expenditures/Assets, MI Tobin’s Q, and Institutional holdings. All independent variables are lagged by one
year. Variable definitions are provided in the Appendix. All regressions include firm and year fixed effects. Standard errors are heteroskedasticity-consistent and
clustered at the firm level. The t-statistics are reported in parentheses.
(1) (2) (3) (4) (5) (6) (7) (8)
Incentives, unvested options 0.0016 0.0023 −0.0059 0.0094 −0.0012 0.0031 −0.0011 0.0033
(1.26) (2.11)** (1.09) (2.31)** (0.57) (2.22)** (0.59) (2.39)**
Incentives, vested options 0.0005 −0.0002 0.0038 −0.0011 0.0007 −0.0006 0.0006 −0.0007
(0.73) (0.39) (1.53) (0.41) (0.76) (0.67) (0.66) (0.74)
Incentives, restricted stock 0.0018 0.0044 0.0072 0.0140 −0.0034 0.0054 −0.0024 0.0033
(0.26) (0.70) (0.31) (0.54) (0.46) (0.65) (0.31) (0.40)
Incentives, unrestricted stock −0.0000 0.0000 0.0001 −0.0001 0.0001 −0.0000 0.0001 −0.0000
(1.04) (1.37) (0.29) (0.59) (0.74) (0.01) (1.67)* (0.00)

R2 0.1801 0.1156 0.3370 0.2249 0.1579 0.1224 0.1559 0.1132
Observations 6,031 7,248 6,031 7,248 6,031 7,248 6,002 7,231
283
option grants. Yermack (1997) documents that the timing of CEO stock option awards
coincides with favorable movements in firm stock prices, as evidenced by abnormally
high firms’ stock returns after executive stock option grants. Chauvin and Shenoy
(2001) and Lie (2005) find that the returns are abnormally low leading up to the
grants. Since nearly all executive stock options are granted at the money and new
grants are nearly always unexercisable, the opportunistic timing of option grants or
retroactive setting of official grant dates will increase the total long-term incentives,
and in particular, the unvested options-based incentives. If the subsequent positive
stock return is also associated with more innovation, it would appear as if higher
unvested options-based incentives resulted in higher innovation outcomes.
Following Chi and Johnson (2009), in untabulated analysis, I add to the baseline
specification a dummy variable equal to 1 if the firm grants either new stock options
or new restricted stock in the fiscal year before the measurement of the innovation
output. This dummy variable is expected to capture the impact of possible managerial
opportunistic actions with regard to new grants.11 I also include the firm’s buy and hold
one-year stock return measured over the fiscal year preceding the measurement of the
innovation output and an interaction term between the new grant dummy and stock
return. The main results remain qualitatively unchanged, and therefore, are unlikely
to be driven by managers’ influence over the terms of their own compensation.
3.4.4. Alternative model specifications

In addition to the firm-year fixed effects regression specification, I also con-
firm the robustness of the main findings by reestimating the baseline specification
replacing firm fixed effects with industry fixed effects.
To further address the truncation bias in patent count, in untabulated analysis,
I follow Hall, Jaffe and Trajtenberg’s (2001) recommendation to take a three-year
“safety lag” and exclude the years 2004–2006 because the truncation bias is most
severe in the last three years of the NBER patent database. The main results are robust
to this subperiod analysis.
I also examine the effect of adding a two-year lag and three-year lag of the
incentive variables to allow for a possible longer lagged effect. The one-year lagged
incentive measures continue to strongly predict a higher number of patents and a
higher impact of patents generated over the year. The findings (untabulated) are thus
consistent with the interpretation that executive incentives that are in place at the start
of the period stimulate greater innovation over the period.
As discussed in Hsu, Lee, Liu and Zhang (2015), aggregate and/or industry-
level omitted variables, including business/economy cycles, industry life cycles,
11 Any such impact on previously granted unvested options would be much less of a concern due to the
difficulty with predicting stock price movement over the longer term and the Securities and Exchange
Commission reporting regulations for stock option grants.
industrial structures, and time-variant innovation opportunities, could potentially

affect empirical tests. To mitigate this issue, they suggest including year dummies
and removing the industry averages from all firm-level variables in an industry fixed
effects specification. As the findings (untabulated) continue to hold in this alternative
specification, they are less likely to be driven by aggregate and/or industry-level
omitted variable bias.
3.4.5. Changes in accounting standards for stock option-based

compensation
Financial Accounting Standards Board (FASB) Statement No. 123 introduces
the fair value-based method for reporting stock option-based compensation expense
as opposed to the intrinsic value-based method. It might appear that, following the
change in accounting standards, stock options might be perceived as more costly
to grant, as reflected in the firm’s disclosed pro forma net income and in terms of
investor-perceived costs associated with option compensation. However, I do not
find evidence of a reduction, after FASB Statement No. 123 has come into effect,
in options-based incentives overall as well as unvested options-based incentives
and vested options-based incentives separately in any group of firms—innovative
industries, noninnovative industries, firms facing higher product market competition,
and firms facing lower product market competition.12,13 More importantly, the results
continue to hold.
3.5. Endogeneity
In the tests discussed so far, I have employed several methods to alleviate endo-
geneity issue caused by the omitted variable bias, such as using an extensive set of
control variables, including fixed effects, and using deviation from industry means.
To further reduce the likelihood that the main results are spurious, in this section,
I perform a number of additional analyses to more thoroughly address endogeneity
concerns, which center on reverse causality and/or joint determination of execu-
tive incentives and corporate innovation. All untabulated results are available on
request.
12 I focus my attention on FASB Statement No. 123, which encouraged the use of the fair value-based
method and came into effect after December 15, 1995 rather than Revised FASB Statement No. 123, which
required the use of the fair value-based method and came into effect after June 15, 2005, for two reasons.
First, due to innovation data availability, my sample ends in 2006. Second, empirical evidence suggests
that the stock option-based compensation expense disclosed under FASB Statement No. 123 appears to
be perceived by investors as value relevant.
13 In fact, the yearly average levels of new options-based incentives as well as unvested options-based
incentives and vested options-based incentives for several years after fiscal year 1995 remain higher than
the corresponding yearly average levels in fiscal years 1992–1995.
Persistence in a firm’s innovation activity can drive the results and represent a
source of reverse causality. I use alternative approaches to address this issue. First, I
add a firm’s average innovation output in the last three years to the firm-year fixed
effects regression specification. This approach is an attempt to address the issue of
strong persistence in a firm’s innovation activity, and at the same time circumvent the
econometric problem of dynamic panel bias arisen from the direct inclusion of the
lagged firm-level dependent variable in the firm-year fixed effects regression. The
results (untabulated) remain unchanged.
As an alternative approach, I include one-year lag of the dependent variable in
the regression and use the Arellano-Bond dynamic panel-data (difference Generalized
Method of Moments (GMM)) estimator, which directly handles dynamic panel bias.
My results (untabulated) continue to hold.
Next, I follow Hsu, Lee, Liu and Zhang’s (2015) empirical approach and add the
lagged innovation output to an industry-year fixed effects regression specification.
As industry fixed effects are used instead of firm fixed effects in this setting, dynamic
panel bias is less likely to be an issue. In this specification, the coefficient on the un-
vested options-based incentives variable reflects the effect of this particular variable
on subsequent innovation output, with the influence of concurrent innovation output
removed or held constant. The results (untabulated) confirm the positive and signifi-
cant relation between managerial unvested options-based incentives and subsequent
innovation output. In a variation on this specification, I include the two-year lag of
the dependent variable instead of the one-year lag. By construction, the two-year lag
of innovation output is lagged by one year relative to the incentives variables. The
main purpose with this variation is to allow for a possible lag in the feedback from
innovation performance to executive incentives. The results (untabulated) remain
unchanged.
Finally, Bae, Kang and Wang (2011) suggest using a change analysis to test
the causal effect. In this analysis, all variables are converted into first differences.
As the analysis relies on time series variations, both reverse causality and omit-
ted variable bias are alleviated. I therefore perform a change analysis for both the
industry-year fixed effects regression specification and firm-year fixed effects re-
gression specification.14 The findings (untabulated) are robust in the change analysis
setting.
I next address the simultaneity concerns with systems of simultaneous equa-
tions. Specifically, for each measure of innovation output (year-adjusted patent
count, index-adjusted citations-per-patent count, year-adjusted citations-per-patent
count and year-and-technology-class-adjusted citations-per-patent count), I use 3SLS
to estimate a system of five equations consisting of one equation for the in-
novation output and one equation for each of the four CEO incentive variables
14 As this regression specification includes firm fixed effects, it is the deviations from the within-firm mean
changes that are utilized in forming all the coefficient estimates.
(unvested options-based, vested options-based, restricted stock-based, and unre-

stricted stock-based incentives). The system is similar in structure to a specification
used in Coles, Daniel and Naveen (2006) and is summarized below:
Innovation outputt+1 = function of {Incentivest , Controlst }

(2)
Incentivest = function of {Innovation outputt+1 , Controlst }.
This specification explicitly allows for the possibility that next year innovation
output impacts the design of current CEO incentives. In other words, I explicitly
assume that next year innovation output and current CEO incentives are jointly
determined. Each equation in a system includes all the control variables described in
Section 2.2.3, including firm and year fixed effects. Furthermore, I note that Coles,
Daniel and Naveen (2006) specify CEO tenure, CEO vega, firm risk and surplus cash
among the determinants of CEO delta—their measure of CEO incentives, where firm
risk is defined as the logarithm of the variance of daily stock returns and surplus cash
is computed as cash from assets-in-place to total assets. I add these four additional
control variables to the incentives equations as well as to the innovation output
equation.
For identification, the set of controls in each incentives equation also includes
two additional explanatory variables. In a related study on the relation between CEO
ownership and firm value, Kim and Lu (2011) argue that personal income taxes
may impact the composition of a CEO’s personal portfolio and the timing of stock
transactions and option exercises, and hypothesize an inverse relation between tax
rates and CEO ownership of stock and options. They suggest using the maximum
tax rates as most firms covered by ExecuComp are relatively large and their CEOs’
marginal income tax rates are likely to fall in the highest bracket most of the time. I
therefore include the sum of maximum state and federal marginal personal income
tax rates on the right-hand side of each incentives equation. The second additional
right-hand side variable in each incentives equation is the corresponding mean CEO
incentives of all firms in the same industry (defined based on two-digit SIC codes)
and year, excluding firm i’s own CEO incentives.
Table 7 reports 3SLS estimates for four systems of simultaneous equations,
one system for each measure of innovation output. I find that unvested options-based
incentives enter positively and significantly in three out of four systems, for all three
citation measures. On the other hand, innovation output in the following year does not
appear to predict current managerial unvested options-based incentives. Compared
with the results reported in previous sections, a notable difference is that I find some
evidence of a negative relation between the short-term (vested) incentives and next
year innovation output, that is, the short-term focus of these incentives appears to have
a discouraging effect on corporate innovation, which by nature requires a long-term
perspective and commitment.
Overall, the results from estimating systems of simultaneous equations using
3SLS are consistent with the hypothesis that long-term incentives, in particular,
Table 7
288
CEO incentives and corporate innovation—systems of simultaneous equations (3SLS)
The table reports 3SLS estimates of four systems of simultaneous equations of innovation output measures and CEO incentives. The innovation output measure
is Ln (1 + YPatent) in Panel A, Ln (1 + ICitePat) in Panel B, Ln (1 + YCitePat) in Panel C, and Ln (1 + YTCitePat) in Panel D. The sample period is 1992–2006.
In each panel, the dependent variable is indicated by the column heading. The unreported common control variables in all equations are Ln (Sales), Ln (1 + Firm
age), ROA, Leverage, PPE/Assets, Hindex, Research and development/Assets, Capital expenditures/Assets, MI Tobin’s Q, Institutional holdings, Ln (1 + CEO
tenure), Ln (1 + CEO vega), Firm risk, and Surplus cash. The innovation output equations (columns 1) also include Hindex squared. All CEO incentives and
control variables are lagged by one year relative to the innovation output variables. Variable definitions are provided in the Appendix. All regressions include
firm and year fixed effects. The t-statistics based on robust standard errors are reported in parentheses.
Panel A: Observations: 12,819
Incentives, unvested Incentives, vested Incentives, restricted Incentives,
Ln (1 + YPatent) options options stock unrestricted stock
(1) (2) (3) (4) (5)
Incentives, unvested options 0.0072
(0.25)
Incentives, vested options −0.0060
(0.39)
Incentives, restricted stock 0.5014
(3.74)***
Incentives, unrestricted stock −0.0011
(0.77)
Ln (1 + YPatent) 1.4337 7.0891 1.6609 −36.6421
(0.58) (1.72)* (4.41)*** (0.63)
MI (−i) Incentives, unvested options 0.1801
(4.02)***
MI (−i) Incentives, vested options 0.0904
(2.20)**
MI (−i) Incentives, restricted stock 0.0075

(0.21)
MI (−i) Incentives, unrestricted stock 0.0533
(1.55)
Tax rate 9.0222 10.3467 −1.3053 −282.4561
(1.08) (0.64) (1.03) (1.28)
Controls Yes Yes Yes Yes Yes
(Continued)
Table 7 (Continued)
Panel B: Observations: 12,819

Ln (1 + ICitePat) options options stock unrestricted stock
(1) (2) (3) (4) (5)
(3.48)***
(2.48)**
(0.83)
(3.43)***
Ln (1 + ICitePat) 0.2435 1.1473 0.1621 −1.6919
(0.57) (1.65)* (1.96)* (0.18)
(4.07)***
(2.41)**
(1.66)*

(1.99)**
Tax rate 6.7322 −7.4224 −4.9529 −175.3655
(0.77) (0.44) (3.11)*** (0.85)
(Continued)
289
290
Table 7 (Continued)
Panel C: Observations: 12,819

Ln (1 + YCitePat) options options stock unrestricted stock
(1) (2) (3) (4) (5)
(3.08)***
(2.07)**
(0.14)
(2.61)***
Ln (1 + YCitePat) 0.6097 4.8587 0.4373 −2.2864
(0.34) (1.58) (1.28) (0.05)
(4.40)***
(2.46)**
(2.40)**

(1.94)*
Tax rate 6.8854 −10.2740 −4.7578 −152.4978
(0.74) (0.57) (2.84)*** (0.65)
(Continued)
Table 7 (Continued)
Panel D: Observations: 12,776

Ln (1 + YTCitePat) options options stock unrestricted stock
(1) (2) (3) (4) (5)
(1.84)*
(1.38)
(1.11)
(1.75)*
Ln (1 + YTCitePat) 0.2846 4.6205 0.5981 −12.8690
(0.14) (1.26) (1.35) (0.25)
(4.49)***
(2.35)**
(1.93)*

(1.78)*
Tax rate 8.3207 −1.2947 −4.0638 −226.1522
(0.94) (0.08) (2.51)** (1.07)
291
incentives stemming from stock options with long vesting periods motivate explo-
ration and innovation, and thus lend credence to the baseline regression results.
3.6. Possible channels

Among the sources of equity-based incentives, unvested options uniquely meet
two conditions for encouraging higher risk taking for the purpose of achieving greater
long-term success—a long-term focus and a convex payoff function. Therefore, a
possible channel for the observed positive and significant relation between unvested
options-based incentives and subsequent corporate innovation is that these incentives
encourage managers to undertake riskier projects. Innovation projects fit well into the
category of riskier projects as they are unpredictable, long-term, multistage, labor-
intensive and idiosyncratic as they involve the exploration of new untested approaches
(Holmstrom, 1989). I investigate this potential channel by examining the implication
of unvested options-based incentives on the volatility of future firm stock returns.
First, high-risk investment projects will increase the volatility of firms’ future cash
flows, which in turn causes firm stock returns to be more volatile. Second, using
equity risk is consistent with the fact that unvested options are a source of equity-
based incentives. Furthermore, the nature of innovation projects implies an increase
in a firm’s unsystematic risk as the firm explores new, uncharted territory; therefore,
it is important to consider the volatility of residual stock returns in addition to the
volatility of raw stock returns.
Specifically, my first volatility measure—Total Risk—is the natural logarithm
of the annualized variance of daily stock returns in fiscal year t + 1. The second
volatility measure—Idiosyncratic (firm-specific) Risk—is constructed after control-
ling for market fluctuations. I use four alternative approaches to constructing this
measure. First, following Cassell, Huang, Sanchez and Stuart (2012), I use daily
stock return data 36 months prior to the beginning of fiscal year t + 1 (i.e., 36 months
up until the end of fiscal year t) to estimate the parameters of the market model. These
estimated parameters are used to construct expected daily stock returns in fiscal year
t + 1. The daily residual stock returns are then obtained as the difference between the
daily realized stock returns and expected returns. Idiosyncratic risk is estimated as
the natural logarithm of the annualized variance of daily residual returns in year t +
1. The second approach follows the spirit of Xu and Malkiel (2003) and has similar
steps, except that daily stock return data 36 months up until the end of fiscal year t +
1 are used in estimating the market model. The remaining two approaches rely on in-
sample estimation of the market model, where daily stock returns over fiscal year t +
1 are regressed on the corresponding daily returns of Center for Research in Security
Prices (CRSP) value-weighted market portfolio, with and without the inclusion of
five leads and five lags of market returns in the regression. The addition of the leads
and lags of market returns is to adjust for nonsynchronous trading (Dimson, 1979).
Idiosyncratic risk is measured with the natural logarithm of the annualized variance
of the residuals from the market model.
I regress each volatility measure on measures of CEO equity-based incentives

and an extensive set of control variables based on existing literature (see, e.g., Coles,
Daniel and Naveen, 2006; Cassell, Huang, Sanchez and Stuart, 2012; among others).
The results are reported in columns 1 and 2 of Table 8. The regression results obtained
with four alternative measures of idiosyncratic risk are qualitatively similar, there-
fore, for brevity, I only report the results using the first approach of estimation. The
evidence supports the interpretation that unvested options-based incentives encour-
age managerial risk taking, as reflected in higher future firm risk. More importantly,
consistent with my expectation concerning the undertaking of innovation projects,
there appears to be a positive relation between unvested options-based incentives and
future firm-specific risk. To gain further insight, in untabulated analysis (results are
available on request), I once again rely on the cross-sectional variations in industry
innovativeness and product market competition for identification purposes. I find
that long-term incentives stemming from the CEO’s holdings of unvested options
are associated with higher total firm risk and higher firm-specific risk in the next
period only within innovative industries and industries with strong product market
competition, that is, where risk taking particularly matters for firms’ long-term
survival and sustainable growth. Overall, the findings from investigating the relation
between managerial equity-based incentives and firm risk taking run parallel to
the reported results concerning the relation between these incentives and corporate
innovation.
Ultimately, firm risk is affected by policy choices. Investment and financial
policies are some of the channels through which executive incentive compensation
can alter firm risk. For corroborating evidence, I also investigate the implication of
CEO equity-based incentives on the riskiness of firm investment and financial poli-
cies. Following Coles, Daniel and Naveen (2006) and Cassell, Huang, Sanchez and
Stuart (2012), I use research and development expenditures scaled by total assets as a
proxy for the riskiness of firm investment policies. Compared with other investment
choices (e.g., capital expenditures), research and development expenditures arguably
are more risky as their future economic benefits are highly uncertain. Furthermore,
research and development expenditures also represent an important input to the
innovation process. As a proxy for the riskiness of firm financial policies, I use
a measure of the liquidity of firm assets—Working Capital—computed as current
assets minus current liabilities scaled by total assets. Holding more liquid assets will
reduce firm exposure to bankruptcy risk. To account for industry-specific factors
that may drive investment and financial decisions, I subtract the corresponding
industry averages from these proxies. The results are tabulated in columns 3 and 4 of
Table 8. As expected, the results show a positive (negative) relation between unvested
options-based incentives and future research and development expenditures (working
capital).
Collectively, the results reported in Table 8 provide empirical evidence suggest-
ing that unvested options holdings provide managers with greater incentives for risk
taking, as reflected in higher future firm risk. The increase in firm risk is achieved, in
294
Table 8
CEO incentives, firm risk and corporate policies
The table presents the results from regressions of firm risk on CEO incentives (columns 1 and 2) and regressions of proxies for the riskiness of firm investment
and financial policies on CEO incentives (columns 3 and 4). The sample period is 1992–2006. The dependent variable is indicated by the column heading. The
unreported common control variables in all equations are Ln (1 + CEO vega), Ln (Total assets), Ln (1 + Firm age), Stock return, MI Tobin’s Q, Sales growth,
ROA, Leverage, and Surplus cash. The firm risk equations (columns 1 and 2) also include Research and development/Assets and Capital expenditures/Assets. All
independent variables are lagged by one year. Variable definitions are provided in the Appendix. Columns 1 and 2 include firm and year fixed effects. Columns
3 and 4 include industry and year fixed effects. Standard errors are heteroskedasticity-consistent and clustered at the firm level. The t-statistics are reported in
parentheses.
Industry-adjusted
research and development Industry-adjusted
Total risk Idiosyncratic risk expenditures working capital
(1) (2) (3) (4)
Incentives, unvested options 0.0069 0.0052 0.0004 −0.0016
(3.83)*** (2.83)*** (1.96)** (2.55)**
Incentives, vested options 0.0011 0.0013 0.0002 −0.0004
(1.30) (1.49) (1.92)* (1.40)
Incentives, restricted stock −0.0034 −0.0066 −0.0007 −0.0036
(0.34) (0.66) (0.85) (1.20)
Incentives, unrestricted stock −0.0000 −0.0001 −0.0000 0.0000
(0.21) (1.13) (2.46)** (0.88)
Controls Yes Yes Yes Yes

R2 0.5454 0.5515 0.4673 0.4971
Observations 12,081 12,076 12,535 12,184
part, through such avenues as implementing riskier corporate policies, in particular,

undertaking riskier investment projects. The main findings reported earlier in turn
suggest that among these riskier investment choices are innovation projects that result
in higher innovation output.
In sum, the evidence supports my hypothesis that a possible channel for the
observed relation between unvested options-based incentives and subsequent cor-
porate innovation is that these incentives encourage managers to undertake riskier
projects to achieve long-term economic benefits. However, other channels could be
at work as well and are likely to be a fruitful area for further theoretical and empirical
research.
4. Conclusions
This paper examines the relation between the CEO’s equity-based incentives and
corporate innovation. I document that long-term incentives, in particular, unvested
options-based incentives are significantly higher among firms in innovative industries,
where substantial opportunities for innovation are available, as well as among firms
operating in more competitive product markets, where the needs for exploration and
innovation to develop a source of sustained competitive advantage are very likely
perceived as more important and urgent. More importantly, I find that higher long-
term incentives that stem from CEO holdings of unvested options are associated with
greater subsequent corporate innovation. Further, utilizing cross-sectional variations
in industry innovativeness and product market competition, I show that the relation is
observed only within innovative industries and industries with strong product market
competition. While the bulk of the CEO’s incentives can be attributed to his/her
holdings of unrestricted stock, short-term (vested) incentives do not appear to be
associated with greater innovation output.
I make several attempts to reduce the likelihood that the results are spurious,
including estimating systems of simultaneous equations. The results from these ro-
bustness tests are consistent with the hypothesis that long-term incentives in the
form of unvested stock options motivate innovation. The evidence thus shows that
not all sources of equity-based incentives are equal when it comes to motivating
innovation. More importantly, the evidence points to a beneficial effect of vesting
restrictions on executive stock and option holdings. This has practical implications
for designing executive incentive schemes, in particular, for managing vesting restric-
tions on executive stock and options to encourage managers to undertake innovation
projects.
I identify a possible channel for the observed relation between unvested options-
based incentives and subsequent corporate innovation, that is, these incentives encour-
age managers to undertake riskier projects to achieve long-term economic benefits.
Given the complexity of the innovation process and the important role of the CEO
in shaping corporate policies, it is possible that other channels might be at work as
well. This likely represents a productive area for further research.
Appendix: Variable definition
Variables Definition
Dependent variables
Ln (1 + Patent) Natural logarithm of 1 plus the number of patents applied for (and
eventually granted) during the year.
Ln (1 + YPatent) Natural logarithm of 1 plus the number of year-adjusted patents
applied for (and eventually granted) during the year. The number
of patents for each firm-year is scaled by the average number of
patents of all firms in the NBER patent database for that year.
Ln (1 + CitePat) Natural logarithm of 1 plus the number of citations received on the
firm’s patents applied for (and eventually granted), scaled by the
number of patents applied for (and eventually granted) during the
year.
Ln (1 + ICitePat) Natural logarithm of 1 plus the number of index-adjusted citations
received on the firm’s patents applied for (and eventually
granted), scaled by the number of patents applied for (and
eventually granted) during the year. Each patent’s citation count
is multiplied by the weighting index from Hall, Jaffe and
Trajtenberg (2001, 2005).
Ln (1 + YCitePat) Natural logarithm of 1 plus the number of year-adjusted citations
received on the firm’s patents applied for (and eventually
granted), scaled by the number of patents applied for (and
eventually granted) during the year. Each patent’s citation count
is scaled by the average citation count of all patents in the same
year.
Ln (1 + YTCitePat) Natural logarithm of 1 plus the number of
year-and-technology-class-adjusted citations received on the
firm’s patents applied for (and eventually granted), scaled by the
number of patents applied for (and eventually granted) during the
year. Each patent’s citation count is scaled by the average citation
count of all patents in the same year and technology class.
Total Risk The natural logarithm of the annualized variance of daily stock
returns in fiscal year t + 1
Idiosyncratic Risk The natural logarithm of the annualized variance of daily residual
returns in fiscal year t + 1. Daily stock return data 36 months
prior to the beginning of fiscal year t + 1 are used to estimate the
parameters of the market model.
Independent variables,
lagged values
Incentives, long-term The change, expressed as a percentage of annual total pay, in the
CEO’s wealth that stems from his/her holdings of unvested
options and restricted stock for a percent change in firm value.
Incentives, short-term The change, expressed as a percentage of annual total pay, in the
CEO’s wealth that stems from his/her holdings of vested options
and unrestricted stock for a percent change in firm value.
(Continued)
Incentives, unvested options The change, expressed as a percentage of annual total pay, in the
CEO’s wealth that stems from his/her holdings of unvested
options for a percent change in firm value.
Incentives, vested options The change, expressed as a percentage of annual total pay, in the
CEO’s wealth that stems from his/her holdings of vested options
for a percent change in firm value.
Incentives, restricted stock The change, expressed as a percentage of annual total pay, in the
CEO’s wealth that stems from his/her holdings of restricted stock
for a percent change in firm value.
Incentives, unrestricted stock The change, expressed as a percentage of annual total pay, in the
CEO’s wealth that stems from his/her holdings of unrestricted
stock for a percent change in firm value.
Firm-level incentives, Top five executives’ incentives from holdings of unvested options,
unvested options obtained by weighting each of the top five executives’ incentives
from holdings of unvested options by the fraction of his/her sum
of salaries and bonuses.
Firm-level incentives, vested Top five executives’ incentives from holdings of vested options,
options obtained by weighting each of the top five executives’ incentives
from holdings of vested options by the fraction of his/her sum of
salaries and bonuses.
Firm-level incentives, Top five executives’ incentives from holdings of restricted stock,
restricted stock obtained by weighting each of the top five executives’ incentives
from holdings of restricted stock by the fraction of his/her sum
Firm-level incentives, Top five executives’ incentives from holdings of unrestricted stock,
unrestricted stock obtained by weighting each of the top five executives’ incentives
from holdings of unrestricted stock by the fraction of his/her sum
Ln (Sales) Natural logarithm of firm sales as proxy for firm size
Ln (1 + Firm age) Natural logarithm of 1 plus firm age. Firm age is approximated by
the number of years since the firm’s first being listed on
COMPUSTAT.
ROA Return-on-assets ratio, computed as operating income before
depreciation divided by book value of total assets.
Leverage Ratio of the sum of long-term debt and short-term debt to book
value of total assets.
PPE/Assets Ratio of net property, plant, and equipment to book value of total
assets.
Hindex Herfindahl index of two-digit SIC industry where the firm belongs.
Research and Ratio of research and development expenditures to book value of
development/Assets total assets. Missing values are set to zero.
Capital expenditures/Assets Ratio of capital expenditures to book value of total assets.
MI Tobin’s Q Market-to-book ratio, computed as market value of equity plus
book value of total assets minus book value of equity minus
balance sheet deferred taxes (set to zero if missing), divided by
book value of total assets. Industry-average Tobin’s Q
(calculated at the two-digit SIC level) is used in the regressions.
(Continued)
Institutional holdings Fraction of shares held by institutional investors, averaged over the
fiscal year.
Ln (1 + CEO tenure) Natural logarithm of 1 plus CEO tenure. CEO tenure is the number
of years as CEO.
Ln (1 + CEO vega) Natural logarithm of 1 plus CEO vega. CEO vega is defined as the
dollar change in a CEO’s option holdings for a 1% change in
stock return volatility, in thousands of 2009 dollars.
Firm risk Natural logarithm of the variance of daily stock returns.
Surplus cash Ratio of cash from assets-in-place to total assets.
Tax rate Sum of maximum state and federal marginal personal income tax
rates.
MI (−i) Incentives, unvested Mean incentives from CEO holdings of unvested options of all
options firms in the same industry (defined based on two-digit SIC
codes) and year, excluding firm i’s own CEO incentives.
MI (−i) Incentives, vested Mean incentives from CEO holdings of vested options of all firms
options in the same industry (defined based on two-digit SIC codes) and
year, excluding firm i’s own CEO incentives.
MI (−i) Incentives, restricted Mean incentives from CEO holdings of restricted stock of all firms
stock in the same industry (defined based on two-digit SIC codes) and
year, excluding firm i’s own CEO incentives.
MI (−i) Incentives, Mean incentives from CEO holdings of unrestricted stock of all
unrestricted stock firms in the same industry (defined based on two-digit SIC
codes) and year, excluding firm i’s own CEO incentives.
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The Financial Review 53 (2018) 255–300

CEO Incentives and Corporate Innovation

Using scaled wealth-performance sensitivity as my measure of Chief Executive Officer

JEL Classifications: G34, O31

2. Data and methodology

2.2. Variable measurement

2.2.2. Measuring incentives

2.2.3. Other explanatory variables

industry concentration is captured by a sales-based Herfindahl index (constructed at

2.3. Baseline specification

Innovation outputi ,t+1 = a + βIncentivesi,t + γ Xi,t + Yeart + Firmi

2.4. Descriptive statistics

Panel A: Innovation variables

Variable Observations Mean Median SD

Panel B: Incentives (wealth-performance sensitivity) variables

Variable Observations Mean Median SD

Panel C: Baseline control variables

Variable Observations Mean Median SD

executive’s holdings of unrestricted stock. On average, the change in compensation,

Panel A: CEO incentives and patent counts, raw and year-adjusted

(1) (2) (3) (4) (5) (6) (7) (8)

Incentives, restricted stock 0.0236 0.0063

Panel A: CEO incentives and patent counts, raw and year-adjusted

(1) (2) (3) (4) (5) (6) (7) (8)

(0.76) (0.65) (0.56) (0.57) (1.24) (1.33) (1.46) (1.45)

Panel B: CEO incentives and citations-per-patent counts, raw and index-adjusted

(1) (2) (3) (4) (5) (6) (7) (8)

Panel B: CEO incentives and citations-per-patent counts, raw and index-adjusted

(1) (2) (3) (4) (5) (6) (7) (8)

Panel C: CEO incentives and citations-per-patent counts, year-adjusted and year-and-technology-class-adjusted

(1) (2) (3) (4) (5) (6) (7) (8)

Panel C: CEO incentives and citations-per-patent counts, year-adjusted and year-and-technology-class-adjusted

(1) (2) (3) (4) (5) (6) (7) (8)

MI Tobin’s Q −0.0124 −0.0128 −0.0135 −0.0135 −0.0067 −0.0071 −0.0078 −0.0077

results in column 4 of Panel C implies that a one-standard-deviation increase in

3.2. Industry innovativeness

Panel A: Summary statistics of Hi and Lo subsamples on industry innovativeness

Hi Lo Mean test (Hi vs Lo)

Variable Observations Mean Median SD Observations Mean Median SD p-Value

Hi Lo Mean test (Hi vs Lo)

Variable Observations Mean Median SD Observations Mean Median SD p-Value

Panel A: Summary statistics of Hi and Lo subsamples on industry innovativeness

Hi Lo Mean test (Hi vs Lo)

Variable Observations Mean Median SD Observations Mean Median SD p-Value

Ln (1 + YPatent) Ln (1 + ICitePat) Ln (1 + YCitePat) Ln (1 + YTCitePat)

Panel B2: CEO incentives and corporate innovation—breakdown of incentives

Ln (1 + YPatent) Ln (1 + ICitePat) Ln (1 + YCitePat) Ln (1 + YTCitePat)

3.3. Product market competition

needs for exploration and innovation to develop a source of sustained competitive

3.4. Robustness checks

Panel A: Summary statistics of Hi and Lo subsamples on product market competition

Hi Lo Mean test (Hi vs Lo)

Variable Observations Mean Median SD Observations Mean Median SD p-Value

Hi Lo Mean test (Hi vs Lo)

Variable Observations Mean Median SD Observations Mean Median SD p-Value

Panel A: Summary statistics of Hi and Lo subsamples on product market competition

Hi Lo Mean test (Hi vs Lo)

Variable Observations Mean Median SD Observations Mean Median SD p-Value

Ln (1 + YPatent) Ln (1 + ICitePat) Ln (1 + YCitePat) Ln (1 + YTCitePat)

(3.00)* (0.21) (3.01)* (0.20)