Performance-based equity incentives, vesting restrictions, and corporate innovation

Based on the institutional background of mandatory requirement of performance-based executive equity incentives, this paper aims to investigate the impacts of executive equity incentives, vesting periods and vesting performance conditions on corporate innovation.

The empirical analysis is based on the detailed data of equity incentives in China’s listed companies from 2006 to 2014, the Tobit method is implemented to estimate the regression coefficients, and the instrumental variable (IV) approach, Heckman two stage regression, propensity score matching and difference-in-difference models are adopted to solve the problem of endogeneity in several robust tests.

This paper documents that equity incentives and vesting periods are significantly and positively related to corporate innovation measured by R&D investment and patent applications, yet requirements on vesting performance impede corporate innovative activities. Specifically, compared with non-equity incentive companies, the R&D investment and the number of patent applications of equity incentive companies are 40 and 46.2 per cent higher, respectively. A one year increase in equity incentive duration can correspondingly increase the R&D investment by 15 per cent and the patent applications by 18.3 per cent. However, a one standard deviation increase in industry-adjusted ROE target reduces corporate R&D investment by 5 per cent and the patent applications by 8.39 per cent. The main empirical findings still hold after several robust tests.

This paper confirms that the impact of performance-based compensation system on corporate innovation depends on its structure. Specifically, the empirical findings suggest that equity incentive plans being correctly designed can enhance corporate innovative activities, but myopic managers will damage the corporate innovation.

This paper investigates the influence of equity incentive structure on equity incentive effect based on the institutional background of mandatory requirement of performance-based executive equity incentives. It provides an opportunity to understand the mystery of equity incentives, which helps to enrich the structure of equity incentive theoretically. The empirical evidence confirms the importance of tolerating short-term failure and extending the horizon of managerial decision-making on promoting innovation. Overall, the research indicates that only well-designed equity incentive plans can promote innovation, which contributes to regulators and practitioners to form a rational understanding of the premise of equity incentives in promoting innovation and provides a reference for their decision-making.