Incentives and Innovation: Evidence from CEO Compensation Contracts

Abstract

We investigate the relationship between chief executive officer (CEO) compensation and innovation. In an empirical examination of compensation contracts of S&P 4, 5, and 600 firms we find that long-term incentives in the form of options are positively related to patents and citations to patents. In addition, convexity of options has a positive effect on innovation. We also find that pay for performance sensitivity (PPS) has no relationship, and golden parachutes have a positive relationship, with patents and citations to patents. Finally, we show that subsequent to project failure managers’ compensation contracts are reset favorably. We provide support for the theory that compensation contracts that offer long-term commitment and protection from failure are more suitable for innovation.