by Olivier Chatain, SMJ Associate Editor
The slow down in investment in innovation in large corporation is obviously concerning but it is also puzzling. In a recent SMJ paper, Trey Cummings and Anne Marie Knott argue that some of that decline may be the unintended consequence of corporations relying on outside CEOs. According to the authors, the emphasis on general managerial skills these outside CEO bring to the organization has a side effect of reducing the CEO’s detailed understanding of the link between long term R&D efforts and the long term performance of the firm.
Why would outside CEOs entail less innovation? A CEO not well versed in the underlying technology will focus on standardized financial benchmarks and evidence of direct internal needs for the R&D efforts. This typically reduces the amount of R&D undertaken as highly prospective projects are hard to evaluate and have no immediate application. The consequence is a short-term surge in efficiency often rewarded by the stock market, but a long term decay in the ability to transform R&D investment into profitability for the firm.
Indeed, Cummings and Knott find that the the firm’s “research quotient”, which measures the relationship between R&D investment and firm revenuue, falls five years after a outsider CEO has been selected. The authors are able to rule out reverse causality concerns (what if outsider CEOs were named because of preexisting weaknesses in R&D?) and explore in detail what kinds of outside CEOs were associated with larger declines in research quotients.
They find that the nomination of outside CEOs with more R&D expertise, such as prior experience in a high-research-quotient firm, or experience in a very similar industry, were less likely to be associated with a drop in research quotient. But the less related the prior industry experience, the greater the R&D decline.
If such decline in research quotient is an unintended consequence, is there something boards can do to still benefit from outside CEOs while mitigating their negative effect on R&D? Cummings and Knott argue that it is possible to design an incentive structure that would sort out CEOs who are knowledgeable about R&D from those who might be tempted to rationalize it out of lack of expertise. According to the authors, a “high-delta” compensation structure, i.e., using long-term performance measures and high variance of rewards, would attract potential CEOs who are comfortable with long-term R&D management and who would eschew R&D strategies that are degrading the long-term capabilities of the firm. By contrast such an incentive structure would penalize CEOs who do not have subject expertise.
Cummings, T. and Knott, A. M. (2018), Outside CEOs and Innovation. Strat. Mgmt. J.. Accepted Manuscript. . doi:10.1002/smj.2792