Equity compensation and the sensitivity of research and development to financial market frictions

When financial market frictions exist, executives may have to decide which investment activities to reduce when internal funds decrease. Expenditures on research and development (R&D) may be particularly vulnerable because of the long-term nature of innovative activity. We find that equity compensation is associated with lower levels of firm R&D expenditures. Rewarding executives to incur more risk has little effect on R&D expenditures, but rewarding executives for higher returns reduces R&D expenditures and makes R&D expenditures more sensitive to financial market frictions. In contrast, cash compensation reduces the sensitivity of R&D expenditures to financial market frictions.

► Controls for endogeneity bias caused by serial correlation when explanatory variables are predetermined. ► Increasing delta reduces R&D spending and makes R&D more sensitive to financial market frictions. ► There is no relationship between vega and R&D. ► Cash compensation makes R&D less sensitive to financial market frictions.