Mergers, Spin-offs, and Employee Incentives

The following post comes to us from Paolo Fulghieri, Professor of Finance at the University of North Carolina, and Merih Sevilir of the Finance Department at Indiana University.

Many mergers are driven by the desire to reduce competition in the product market and to develop new products to enter into new markets. In our paper, Mergers, Spin-offs, and Employee Incentives, forthcoming in The Review of Financial Studies, we argue that these two motives may be in conflict with each other in that mergers reducing product market competition have a negative effect on employee incentives to innovate and develop new products.

On one hand, mergers reduce the product market competition and increase expected payoffs from employee innovations. On the other hand, by reducing the number of firms in the product market, mergers limit employee ability to go from one firm to another with a negative effect on incentives. Moreover, mergers create internal competition between the employees of the post-merger firm, with an additional negative effect on incentives to innovate. When the negative effects of the merger on incentives are sufficiently large, firms are better off competing in the product market and competing for employee human capital rather than merging and eliminating competition. In other words, firms prefer not to merge and bear competition in the product market to maintain stronger employee incentives. In this way, our paper is consistent with the recent concerns voiced in the context of the AT&T and T-mobile merger, whereby practitioners have suggested that it will hamper incentives to innovate, as we argue in this paper.

Our results on the negative effect of mergers on employee incentives have interesting implications for spin-off transactions. Our paper suggests that a multidivisional firm can create value by undertaking a spin-off transaction since reducing firm size can have a positive effect on employee incentives. This incentive benefit can be sufficiently strong that the spin-off leads to greater firm profits even at the loss of the co-insurance benefit of an internal capital market within the multidivisional firm, and economies of scale from having multiple divisions. Similarly, our paper suggests that a monopoly firm may benefit from creating its own competition in the product market and in the market for human capital when employee bargaining power is low, and when the industry is at an intermediate stage of its life cycle.

We also study how firms can improve employee mobility through their location choices and use of no-compete agreements. Our analysis shows that firms will choose to locate closer to similar firms in order to enhance employee incentives, although doing so exposes them to greater competition in the product market and in the market for employee human capital. Similarly we show that firms will improve employee mobility by adopting less restrictive no-compete agreements, or by locating in regions where such agreements are not enforced. The desire to do so is greater when there is more to gain from being ahead of the competing firms.

Our paper focuses mainly on horizontal mergers between firms operating in similar product markets and is silent about mergers across unrelated industries. Similarly, firms in our model are homogenous in the sense that when merged into a single firm, there can be synergies only through economies of scale rather than economies of scope. It would be interesting in future research to study the effect of mergers on employee incentives if mergers combine two firms where employee innovations complement each other and developing them together creates synergies from economies of scope.

The full paper is available for download here.

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