To innovate or not to innovate when times are bad

Abstract

Are managerial incentives to innovate affected by financial crises? We document that awarding CEOs with stock options in bad times increases their incentives to invest in risky projects and produce innovation. We find that an exogenous increase in CEO option pay awarded during times of high bank distress is associated with an increase in both the quantity and quality of innovation produced by the CEO’s firm. In contrast, the same increase in option pay awarded during normal times does not have a significant effect on firm innovation. We rationalize our results using the Schumpeter’s theory of creative destruction where managers choose to exploit unique growth opportunities that arise during crises. We argue that, during crises, the opportunity costs of not-innovating dominate managerial risk aversion. This is particularly true for firms with high market power (incumbents), firms with less risk-averse CEOs, or less financially-constrained firms. Exogenous variation in option compensation is identified using pre-negotiated multiyear option plans.

Keywords: Innovation, Crises, Executive Compensation, Managerial Incentives, Financial Constraints

JEL Classification: G01, G34