Is your company taking enough risks?
Managing a company is a challenge. CEOs need to balance short-term profit with long-term innovation, performance with investment, and shareholders’ interests with employees’ expectations.
Some CEOs are natural risk-takers; others may be more risk-averse. Managers need to strike the right balance between “doing what works” and investing in risky innovation.
Illustration by Scotty Reifsnyder
“But managers are generally more risk-averse than shareholders,” says Connie Mao, professor and Joseph E. Boettner Senior Research Fellow in the Department of Finance at the Fox School.
With their reputations, wealth and human capital at stake, managers are typically less likely to take on risky innovative projects than shareholders would like. For executives, innovation means potential failure; for investors, big risks beget big rewards. And these company shareholders have a safety net that managers don’t: diversified wealth, stemming from investments in many other stocks. Managers’ wealth, on the other hand, is mostly tied to the company.
So how can shareholders—and public policy—affect executive compensation contracts to encourage managers’ willingness to take risks and invest in innovation?
Mao explains that stock options are commonly used to align managers’ incentives with shareholders’. When the company does well, managers benefit from an increased value in their stock, just like shareholders. But when the company performs poorly, managers do not lose. Until now, no one has determined if these incentives motivate a manager’s decision to invest in innovation.
Mao and her co-author Chi Zhang of the University of Massachusetts at Lowell used a 2005 financial accounting standard, called FAS 123R, to better understand that causal effect. In a pre-FAS 123R world, companies gave out stock options like candy. After 2005, however, companies have to deduct these options from their bottom line, because the standard required companies to change stocks’ value from intrinsic to fair, or market, value in the income statement. The researchers compared a firm’s change in executive compensation and innovation output.
“We used this regulation shock to understand the causation,” says Mao.
The researchers compared companies’ innovation output—measured by the number of patents and others’ citations of those patents—with the changes in the stock options given to CEOs. Mao and Zhang analyzed 6,552 firms’ behavior between 2002 and 2008.
“We documented a significant reduction in patent quantity and quality after the adoption of FAS 123R,” says Mao. This means that “investments in risky innovation projects are dampened due to reductions in option-based compensation as a result of the accounting regulation.”
Innovation is an important economic driver; knowing how to pull that lever appropriately is key to any company and economy. “This study can help boards of directors to design an appropriate executive compensation contract to motivate a manager to invest in innovative projects,” says Mao. “You need to provide managers the right incentive to adopt innovation to move the company, move the economy and move society.”
Mao and Zhang reported their findings in “Managerial Risk-Taking Incentive and Firm Innovation: Evidence from FAS 123R,” published by the Journal of Financial and Quantitative Analysis.
So next time when you’re wondering why a manager is making certain decisions about where to invest a companies’ resources, consider the incentives at play. Will a risky decision be penalized if it doesn’t produce immediate profits? Or will playing it safe keep a manager in the job? Armed with a background of accounting regulations, we can better understand otherwise puzzling choices.