Make or Buy New Technology - a CEO Compensation Contract's Role in a Firm's Route to Innovation
36 Pages Posted: 31 Oct 2003
Date Written: July 2004
Firms obtain new technology either through internal R&D or through acquisitions. These two approaches are usually labeled as "make" and "buy" strategies. In this paper, I examine the relation between a firm's choice of "make" or "buy" and the performance measures used in the firm's CEO compensation contract. I focus on the two major differences between the "make" and "buy" strategies: risk levels and accounting treatment. I hypothesize that the high risk level and unfavorable accounting treatment associated with "make" strategy relative to "buy" strategy lead risk-averse managers to favor "buy" over "make," should they be compensated heavily using accounting-based performance measures. Stock-based compensation, especially stock options, on the other hand, should encourage managers to innovate more through "make" strategies instead of "buying" them from the outside. Using data from US high tech industries, I find evidence consistent with the above hypotheses.
Keywords: R&D, Acquisition, Compensation, Technology
JEL Classification: M41, J33, O31
Suggested Citation: Suggested Citation