Long-term incentives Moqi Groen-Xu, London School of Economics Prepared for LBS governance conference June 2, 2015

Long-term incentives: why? how? …and what are the effects?

Method Data Yearly Qrt/Mth Summary Whatevs 3/21 Why should we set long-term incentives?

Method Data Yearly Qrt/Mth Summary Whatevs 4/21 Classic Example Noda-Bower (1996): Investment into wireless communication in the 1980s  high uncertainty about potential  product scope and technology not clear Example

Whatevs 5/21 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 Whatevs 6/21 learn about payoff distribution of ideas Two stages of investment (Manso) Exploration Exploitation invest into project with best (known) payoff distribution

Method Data Yearly Qrt/Mth Summary Whatevs 7/21 How can we set long-term incentives?

Method Data Yearly Qrt/Mth Summary Whatevs 8/21 How can we set long-term incentives? Equity compensation Fixed-term contracts

Method Data Yearly Qrt/Mth Summary Whatevs 9/21 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 length Joint work with Juanita Gonzalez-Uribe Looks at the effects of contract horizon on innovation (patenting activity)

Method Data Yearly Qrt/Mth Summary Whatevs 10/21 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 Whatevs 11/21 Equity vesting and sales

Fixed-term contracts Whatevs 12/21

Patricia Russo at Lucent Whatevs 13/ Appointment T-5 T-4T-3 T-2 T-1 T

Data Results Qrt/Mth Summary Whatevs 14/25 Contract termination

Method Data Yearly Qrt/Mth Summary Whatevs 15/21 What are the effects of long-term incentives?

Method Data Yearly Qrt/Mth Summary Whatevs 16/21 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 Whatevs 17/21 Strategic news releases in equity vesting months

Method Data Yearly Qrt/Mth Summary Whatevs 18/21 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 Whatevs 19/21

Exploration and exploitation Whatevs 20/21 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

Long-term incentives 2 mechanisms: equity compensation fixed-term contracts 2 effects (today): news releases innovation