Liandong Zhang is Professor of Accounting, Singapore Management University. This post is based on a recent paper by Professor Zhang; Yuyan Guan, Associate Professor at City University of Hong Kong; Liu Zheng, Associate Professor at City University of Hong Kong; and Hong Zou, Associate Professor of Finance at University of Hong Kong.
Innovation is vital to the development of core competitive advantages of a firm and to the economic growth of a country (Solow, 1957). By nature, innovation is a risky, costly, and long-term process fraught with failures (Holmstrom, 1989). A salient difficulty that has long been noted by both academics and practitioners is that risk-averse company directors and officers (D&Os) tend to be reluctant to commit to investment in risky research and developments (R&D) even though such investments may create long-term value (Aghion, Van Reenen and Zingales, 2013; Barton and Wiseman, 2015). As Jensen has highlighted, an important source of D&Os’ reluctance is the potential litigation risk. In particular, some investors may have a low tolerance of innovation failures and the resulting lackluster performance, and may challenge a firm’s innovation inefficiency, as can be seen from the following example.
