Process Intangibles and Agency Conflicts

Abstract

We study how process-focused intangible capital affects firm investment and compensation. We document that, in the cross-section, investment and executive compensation are both increasing in process intangibility, defined as the share of process intangibles in total capital stock. To explain these patterns, we build a dynamic agency model with two key ingredients: (i) physical investment and process innovation are complementary in driving the growth of efficiency-adjusted capital; (ii) due to its opaque nature, process innovation is susceptible to moral hazard problems. The model not only accounts for the positive relations between process intangibility, investment, and compensation, but also predicts that the pay-process intangibility association will be stronger among firms with high physical investments. Finally, it implies that pay-equity measures that restrict the compensation of executives and skilled labor, especially those associated with process innovation, could depress investment and reduce firm value.

Keywords: Process Intangibles, Intangible capital, Dynamic contracting, Compensation

JEL Classification: D21, E22, G31, G32, L22, O31, O34