Tournament Incentives and Firm Innovation

A growing sentiment following the recent financial crisis is that CEOs are overpaid and that their large compensation dilutes shareholder value. This sentiment is partly rooted in the fact that the pay disparity between CEOs and other employees has rapidly grown over the last three decades. Recent evidence shows that non-CEO executives on average earn only approximately 40% of a CEO’s compensation, and the ratio between average CEO pay and worker pay is now around 300-to-1 (Fortune.com, 2015). To shed light on the pay disparity, the U.S. Securities and Exchange Commission (SEC) recently adopted the Pay Ratio Disclosure Rule that requires public companies to disclose the CEO-Employee pay ratios. Why is the large pay disparity in corporate America so prevalent? Is it only driven by the increased CEO power (Bebchuk et al., 2002)? Is it possible that such a large pay disparity may generate certain benefits to firms and shareholders? According to the classical tournament theory (Lazear and Rosen, 1981), pay gaps between hierarchy levels can encourage competition among employees and provide promotion-based incentives (also known as tournament incentives). In a CEO-promotion tournament, non-CEO senior executives compete with each other for the top position. These executives are evaluated relative to their peers (i.e., relative performance evaluation), and among them the best relative performer will be promoted to be the next CEO. Since a promotion to the CEO position is associated with higher pay, senior executives have strong incentives to expend great effort to enhance the corporate performance in order to increase their own chances of promotion. These discussions suggest that large pay gaps could be associated with better firm performance (including better innovation performance).

In our article, Tournament Incentives and Firm Innovation, which was recently accepted for publication in the Review of Finance, we examine the relation between pay disparity and firm innovation. In this study, the pay gap between a CEO and the next layer of senior executives is used to measure promotion-based tournament incentives for non-CEO senior executives (VPs). According to tournament theory, we should expect a positive relation between pay gap and firm innovation performance. However, in addition to inducing greater effort, the option-like payoff structure of a tournament also influences risk-taking behaviors of tournament participants. Prior studies theoretically discuss that in winner-take-all tournament contests, such as sport contests or CEO-promotion tournaments, the contestants face limited negative outcome if they lose, but get the top prize if they win. The contestants therefore have incentives to engage in excessive risk-taking behaviors. Consistent with this view, prior empirical studies on professional sports find that a rank-order tournament induces some contestants to engage in inefficient risk-taking behaviors that lead to poor performance. For example, a study analyzing the statistics of NASCAR racing games finds that when the tournament prize spread is greater, drivers are more likely to take aggressive and hazardous actions, leading to greater likelihood of car accidents. Thus, it is a valid concern that high tournament incentives might actually lead to excessively risky and inefficient innovative activities and, as a consequence, have a destructive impact on corporate innovation performance.

Taken together, it is an empirical question whether tournament incentives induced by large pay gaps are positively or negatively related to firm innovation. To examine this issue, we measure corporate innovative efficiency using the number of patents and patent citations generated per million dollars of R&D expense. Using a large sample of U.S. public firms, we find that tournament incentives are positively related to corporate innovative efficiency, providing fresh evidence to support the classical tournament theory. We also conduct tests to examine whether our main finding is robust to alternative measures of firm innovation performance. First, patents that cite other patents in dispersed technology classes are often believed to have greater “originality”; patents that are cited by patents in a dispersed array of technology classes are viewed as having greater “generality” (Hall et al., 2001). We find that tournament incentives are positively related to the generality and originality indices, which capture the fundamental importance of the patents. Second, Kogan et al., (2016) propose that economic value of each innovation can be estimated based on stock market reaction to patent grants. We find that tournament incentives are positively related to stock market reactions to patent grants, providing more direct evidence that tournament incentives induced by large pay gap increase firm value and shareholder wealth.

If tournament incentives are indeed positively related to innovation, such a positive relation should be most pronounced when a succession contest is likely to occur, such as during the period prior to CEO turnovers. We find evidence in support of this conjecture. In addition, with the assumption that ex-ante expectations of VPs are on average correct, the effect of tournament incentives should be weaker in ex-post outsider-CEO turnover cases (i.e., an outsider is later appointed as a new CEO), ceteris paribus. Consistent with this argument, we find that the positive effect of tournament incentives prior to CEO turnovers is particularly pronounced when an insider (i.e., one of the VPs) is eventually appointed as the new CEO. In a similar vein, we also find that the tournament incentive effect is stronger when VPs expect a higher probability of CEO turnover in the foreseeable future (i.e., when the incumbent CEO is approaching retirement or is underperforming).

We also conduct a variety of ancillary tests. To address the endogeneity issues, we conduct an instrumental-variable regression analysis and also estimate the baseline regressions based on a propensity-score matched sample. Our main findings hold in these analyses. These test results partially mitigate the endogeneity concerns. Additionally, our subsample tests suggest that not every company benefits equally from providing executives with a high CEO-VP pay gap. Specifically, tournament incentives seem to have less beneficial effects on innovative efficiency for family firms, firms with weak corporate governance, and firms in non-innovative industries. In untabulated tests, we also find that the pay gap between executives and lower-ranking employees is significantly and positively related to firm innovation.

Our study contributes to the literature in three ways. First, our study is the first one showing that tournament incentive induced by a large pay gap is also a factor influencing the efficiency of corporate innovative activities and thus adds to the fast-expanding literature on firm innovation. Second, prior studies present mixed evidence on the relation between tournament incentives and firm performance. Given the inconclusive evidence, we explore the effect of tournament incentives on a more proximal performance indicator—firm innovation. Through the lens of firm innovation performance, this study adds fresh evidence to the executive compensation literature by showing that promotion-based incentives enhance firm performance. Third, this study also has a policy implication. It is well known that both CEO-VP and CEO-worker pay gaps keep rising in recent decades, and prior studies (e.g., Bebchuk et al., 2002) have attributed this phenomenon to increased CEO power and agency problems. Our study contributes by offering an additional explanation to this phenomenon. That is, as innovation becomes more important to businesses in recent decades, firms might choose to significantly increase pay gaps between hierarchy levels in order to incentivize executives and other employees to achieve better innovation performance.

The full article is available for download here.