Long-term incentivesMoqi Groen-Xu, London School of Economics

Prepared for LBS governance conferenceJune 2, 2015

Long-term incentives: why?how?

…and what are the effects?

Method Data Yearly Qrt/Mth Summary Whatevs3/21

Why should we set long-term incentives?

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Classic Example Noda-Bower (1996): Investment into wireless communication in the 1980s

high uncertainty about potentialproduct scope and technology not clear

Example

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• one of “Bells” from AT&T breakup

• required quick break-even and high net income contribution

• “cream-skimming”• diversification into real estate

US West vs BellSouth

US West Bell South

• one of “Bells” from AT&T breakup

• emphasis on growth in project selection

• CEO with “pet projects”

• heavy investment into cellular market

Strategy

Method Data Yearly Qrt/Mth Summary Whatevs6/21

• learn about payoff distribution of ideas

Two stages of investment (Manso)

Exploration Exploitation1 2

• invest into project with best (known) payoff distribution

Method Data Yearly Qrt/Mth Summary Whatevs7/21

How can we set long-term incentives?

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How can we set long-term incentives?

Equity compensation Fixed-term contracts

Method Data Yearly Qrt/Mth Summary Whatevs9/21

Joint work with • Alex Edmans• Luis Goncalves-Pinto• Yanbo Wang

Looks at the effects of equity vesting on the timing of news releases

Two studies

Compensation Contract length1 2

Joint work with• Juanita Gonzalez-Uribe

Looks at the effects of contract horizon on innovation (patenting activity)

Method Data Yearly Qrt/Mth Summary Whatevs10/21

Long-term equity compensation

• Example: John Eyler/Toys”R”Us• Source: Filing 4/Proxy statement footnotes• On average 3 years of vesting per grant

Method Data Yearly Qrt/Mth Summary Whatevs11/21

Equity vesting and sales

Fixed-term contracts

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Patricia Russo at Lucent

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2002 2003 2004 2005 2006 2007

Appointment

T-5 T-4 T-3 T-2 T-1 T

Data Results Qrt/Mth Summary Whatevs

0%

2%

4%

6%

8%

10%

12%

5 4 3 2 1

Remaining years

All contracts

0%

2%

4%

6%

8%

10%

12%

5 4 3 2 1

Remaining years

Renewed contracts

14/25

Contract termination

Method Data Yearly Qrt/Mth Summary Whatevs15/21

What are the effects of long-term incentives?

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News releases lead to a temporary increase in stock price and trading volume

Executives personally benefit from news releases shortly before they sell

Strategic news releases

Method Data Yearly Qrt/Mth Summary Whatevs17/21

Strategic news releases in equity vesting months

Method Data Yearly Qrt/Mth Summary Whatevs18/21

• Today: news releases• Incentives for the upside• Can be replenished over

time: set long- and short term incentives at the same time

Long term incentives in comparison

Compensation schedule Contract length

• Today: innovation• Tolerance for failure• Hard to replenish over

time – “evergreen” contracts set incentives until the next renewal date

Innovation

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T-5 T-4 T-3 T-2 T-10

0.1

0.2

0.3

0.4

0.5

0.6

0.795% Confidence IntervalCoefficient Estimate

Time to contract expiration

Scal

ed p

aten

t cita

tions

Exploration and exploitation

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CEOs with less time remaining under contract produce patents that are

• More focused (less dispersion throughout technology classes)

• Less varied in quality variety

• Less general (more dispersion across technology classes of subsequent innovations that cite the patent)

• Less likely to be in a technology class new to the firm

• Less likely to be filed by a new inventor

• More likely to be based on prior innovations filed by the firm

T-5 T-4 T-3 T-2 T-1

-0.2

-0.15

-0.1

-0.05

0

0.05 Technological focus

-1012345678 Quality variety

Long-term incentives

2 mechanisms: equity compensationfixed-term contracts

2 effects (today): news releasesinnovation