The Influence of Outside Directors' Stock‐Option Compensation on Firms' R&D

• Published date: 01 September 2007
• Author: Yuval Deutsch
• Date: 01 September 2007
• DOI: http://doi.org/10.1111/j.1467-8683.2007.00611.x

The Inf‌luence of Outside Directors’

Stock-Option Compensation on

Firms’ R&D

Yuval Deutsch*

Using a sample of S&P 1500 f‌irms between 1997 and 2000, this paper examines the effects of

outside directors’ stock-option compensation on f‌irms’ R&D intensity. Results suggest that

including stock options in outside directors’ compensation enhances f‌irms’ R&D. Moreover,

stock-option compensation moderates the relationship between board composition and R&D

intensity. These results suggest that outside directors’ compensation schemes do matter. The

results also highlight the need to re-evaluate previous f‌indings that addressed the effects of

board composition on both f‌irms’ performance and strategic decisions.

Keywords: R&D, stock-options, compensation, corporate governance

The inf‌luence of outside directors’

stock-option compensation

on f‌irms’ R&D

The last decade has witnessed a trend

toward including stock options in outside

directors’ compensation (Daily et al., 2003).

This trend is manifested not onlyin the greater

percentage of corporations that now include

stock-based compensation in directors’ pay,

but also in a rise in the relative weight of

incentive pay as a part of overall directors’

compensation. Whereas in 1990 only 17 per

cent of f‌irms included some form of stock-

based pay in their directors’ compensation, by

1996 this f‌igure had reached nearly 80 per cent,

and some f‌irms have begun to compensate

their directors exclusively with stock-based

compensation (Daily et al., 1999). Furthermore,

a recent study indicated that among 250 large

industrial and service corporations in the US,

equity now accounts for nearly 50 per cent of

the total director fees (Longnecker, 2004).

The institutional investor community has

been an active proponent of including stock-

based compensation as a complementary

measure to increasing the representation of

outside directors on corporate boards. The

main rationale is that stock-based compensa-

tion more closely aligns directors’ goals to

those of shareholders and provides incentives

for vigilant board monitoring of management

decisions (Carey et al., 1996), and for providing

performance-enhancing resources and advice

(Hillman and Dalziel, 2003). In contrast, Daily

et al. (1999) warn that corporations that adopt

stock-based compensation for outside direc-

tors enter a potential minef‌ield. These authors

suggest that f‌irms should be cautiousin adopt-

ing this practice, at least until there is sound

evidence that this compensation scheme

does in fact benef‌it stockholders. This debate

reveals that to date we simply do not know

whether including stock-based compensation

in outside directors’ pay enhances boards’

performance.

This paper attempts to begin to f‌ill this

important gap in our knowledge. Specif‌ically, I

examine the relationship between the level of

stock-option components in outside directors’

pay and f‌irms’ R&D expenditures. An exami-

nation of f‌irms’ R&D spending provides a

good indication of board effectiveness because

investment in R&D represents a strategic deci-

sion in which managers and shareholders have

conf‌licting interests (Hansen and Hill, 1991).

This approach is consistent with numerous

studies that have evaluated the effectiveness of

*Address for correspondence:

York University, Schulich

School of Business, 4700

Keele Street, Toronto, Ontario,

M3J1P3, Canada. Tel: +1 (416)

7362100 ext. 77895; Fax: +1

(416) 736 5762; Email:

ydeutsch@schulich.yorku.ca

816 CORPORATE GOVERNANCE

Volume 15 Number 5 September 2007

© 2007 TheAuthor

Journal compilation © 2007 BlackwellPublishing Ltd, 9600 Garsington Road,

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