Managerial Short-Termism and Corporate Innovation Strategies *

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1 Managerial Short-Termism and Corporate Innovation Strategies * Huasheng Gao Nanyang Business School Nanyang Technological University S3-B1A-06, 50 Nanyang Avenue, Singapore hsgao@ntu.edu.sg Po-Hsuan Hsu Faculty of Business and Economics University of Hong Kong Pokfulam Road, Hong Kong paulhsu@hku.hk Kai Li Sauder School of Business University of British Columbia 2053 Main Mall, Vancouver, BC V6T 1Z kai.li@sauder.ubc.ca First version: September, 2013 This version: May, 2014 Abstract In this paper we employ a sample of public and private firms to examine the impact of managerial shorttermism associated with public capital market on innovation strategies. We show that public firms patents are less exploratory and more exploitative than private firms patents. The results based on propensity score matching, the IPO firms and their matched private (public) control firms, and the instrumental variable approach reinforce the findings from the cross-section. We then identify a number of possible underlying forces behind managerial short-termism: a higher fraction of vested stock and option grants in CEOs overall equity incentive portfolios, a higher likelihood of a firm becoming a takeover target due to low valuation, and a greater presence of short-term institutional investors. We conclude that managerial shorttermism associated with public capital market leads to an innovation strategy that emphasizes short-term success and potentially underinvests in revolutionary technologies. Keywords: exploitative innovation; exploratory innovation; innovation strategies; managerial shorttermism; patents; private firms JEL Classification: G32; O32 * We are grateful for helpful comments from Andres Almazan, Jan Bena, Bill Kerr, Alexander Ljunqgvist, Gustavo Manso, Ron Masulis, Hernan Ortiz-Molina, Jay Ritter, Cheng-Wei Wu, Ting Xu, seminar participants at Boston University, Harvard Business School, Nanyang Technological University, National Chengchi University, University of British Columbia, University of Hong Kong, University of Oklahoma, and conference participants at the 21 st Conference on the Theories and Practices of Securities and Financial Markets (Kaohsiung). We acknowledge dedicated effort of our research assistants Rita Lei Chen, Yi Du, Cherry Guo, Jialing Hu, and Chi-Yang Tsou. Gao acknowledges financial support from the Tier One Research Grant provided by the Ministry of Education of Singapore. Gao and Li acknowledge financial support from the Social Sciences and Humanities Research Council of Canada. All errors are our own.

2 Managerial Short-Termism and Corporate Innovation Strategies Abstract In this paper we employ a sample of public and private firms to examine the impact of managerial shorttermism associated with public capital market on innovation strategies. We show that public firms patents are less exploratory and more exploitative than private firms patents. The results based on propensity score matching, the IPO firms and their matched private (public) control firms, and the instrumental variable approach reinforce the findings from the cross-section. We then identify a number of possible underlying forces behind managerial short-termism: a higher fraction of vested stock and option grants in CEOs overall equity incentive portfolios, a higher likelihood of a firm becoming a takeover target due to low valuation, and a greater presence of short-term institutional investors. We conclude that managerial shorttermism associated with public capital market leads to an innovation strategy that emphasizes short-term success and potentially underinvests in revolutionary technologies. Keywords: exploitative innovation; exploratory innovation; innovation strategies; managerial shorttermism; patents; private firms JEL Classification: G32; O32

3 1. Introduction Technological innovation represents modern corporations endeavor to develop and accumulate knowledge, and has long been recognized as the catalyst to economic growth and productivity increase (Solow, 1957; Romer, 1990) and a key factor in competitive advantage of nations (Porter, 1998). The management literature has identified two main strategies in organizational learning trajectories: exploratory innovation and exploitative innovation. Exploratory innovation is radical innovation to meet the needs of emerging customers or markets. It requires new knowledge or departure from existing knowledge, and its payoffs take longer time to realize and are of higher uncertainty. In contrast, exploitative innovation is incremental innovation to meet the needs of existing customers or markets. It builds on existing knowledge and reinforces existing skills, processes, and structures, and its payoffs realize faster with less uncertainty (Levinthal and March, 1993; McGrath, 2001; Benner and Tushman, 2002; Smith and Tushman, 2005). In reality, firms have to constantly refine their current technologies to ensure stable future profits and maintain market shares, and in the meantime, they also must invest in new knowledge and market opportunities to hedge against revolutionary technologies that may reshape the whole industry structure. March (1991) posits that maintaining an appropriate balance between exploratory and exploitative innovation is critical for firm survival and prosperity. Levinthal and March (1993, p. 105) further argue that, The basic problem confronting an organization is to engage in sufficient exploitation to ensure its current viability and, at the same time, to devote enough energy to exploration to ensure its future variability. (Also see Lavie, Stettner, and Tushman, 2010 for a review.) Empirically, Katila and Ahuja (2002) find that a firm s ability to create new products is determined by both the independent and interaction effects of exploratory and exploitative innovation. Using a sample of manufacturing firms, He and Wong (2004) show that the interaction between explorative and exploitative innovation strategies is positively related to sales growth rate, while the relative imbalance between explorative and exploitative innovation strategies is negatively related to sales growth. Uotila, Maula, Keil, and Zahra (2009) further show that both over-exploitation and over-exploration hurt firm value as measured by Tobin s Q. Akcigit and Kerr (2012) find that growth spillover effects are larger from exploratory innovation than from exploitative innovation. 1

4 Despite the important heterogeneity in corporate innovation strategies and their distinct effects on new product development and revenue growth, almost everything we know about innovation at the firm level is based on patent and citation counts. Moreover, given the great dependence of firms on public stock markets to finance their R&D (Brown, Fazzari, and Petersen, 2009), understanding the influence of public stock markets on corporate innovation strategy is an important but under-explored research question. This paper aims to fill a gap in the literature by highlighting heterogeneous innovations and providing insights into drivers of innovation strategies. In this study we compile a database of patent and financial information on both public and private firms to help identify key influences of public capital market on innovation strategies. We posit that both sources of financing and managerial short-termism should affect innovation strategies. On the one hand, access to public equity relaxes financial constraints and encourages more risk-taking learning in public firms, resulting in them generating more patents and doing more exploratory innovation than private firms. On the other hand, the pressure to deliver near-term results and the presence of an active takeover market lead public firm managers to take the short-cut by engaging in low-risk learning, resulting in them generating fewer patents and doing more exploitative innovation than private firms. Our use of both public and private firms sharpens the contrasting effects of the financing channel and the managerial short-termism channel on innovation strategies. Further, the innovation strategy of private firms is in itself of great interest to financial economists and management researchers due to a lack of data prior to our study. Using a large sample of public and private US firms from , we first show that public firms generate significantly more patents than private firms, consistent with the predictions of the financing channel. More importantly, we show that public firms patent portfolios are more exploitative (i.e., mainly making use of existing knowledge) and less exploratory (i.e., in pursuit of new knowledge) than private firms patent portfolios. We also show that public firms patent portfolios tend to be narrower in scope but greater in depth in terms of the knowledge domain. These findings support the predictions of the managerial short-termism channel. We recognize that our investigation is vulnerable to selection concerns and we take a number of approaches to addressing them. First, we employ propensity score-matched public control firms and 2

5 compare them with the private firm sample. We find that private firms produce significantly more exploratory (fewer exploitative) patents than their matched public control firms. Second, we employ a transitioning sample of the IPO firms and their matched private (public) control firms. We find that compared to their private peer firms, these newly-public firms experience a significant increase (decrease) in exploitative (exploratory) patents following the IPO; while compared to their public peer firms, these newly-public firms have significantly more (fewer) exploratory (exploitative) patents before the IPO. Moreover, we find that innovation strategies do not explain a firm s decision to go public, suggesting that our findings are not mostly driven by reverse causality. Third, we apply a treatment regression approach with the industry-level IPO underwriter concentration as the instrumental variable to address the selection issue that companies may choose to stay private. We find that the differences in strategies exploratory versus exploitative innovation are even greater between public and private firms after controlling for selection. Finally, we conduct within-public firm analyses to sharpen our evidence for the underlying forces behind managerial short-termism. Our premise is that being public firms, there is a great emphasis on short-term performance (Porter, 1992; Graham, Harvey, and Rajgopal, 2005), maybe even more so than being private firms. If we show that the differences in innovation strategies between high and low shorttermism public firms, sorted by different sources of the short-term performance pressure, are consistent with those between public and private firms, we can conclude that managerial short-termism associated with public capital market is a key driver of corporate innovation strategies. To do so we sort the public firms in our sample based on the vesting horizon of their CEOs equity incentive portfolios, their exposure to the market for corporate control, and their susceptibility to transient institutional investors, and then examine the differences in innovation strategies within different groups of the public firm sample. We classify a public firm to be of high short-termism if the ratio of its CEO s vested stock and option grants to her total holdings of stock and option grants is above the sample median. CEOs with a larger fraction of their equity incentive portfolios vested are subject to more pressure to meet short-term performance targets. We find that firms whose CEOs have a short-term focus are associated with more exploitative and less exploratory innovation. Using the takeover exposure model of Cremers, Nair, and John (2009) and Fang, Tian, and Tice (2013), we classify a public firm to be of high short-termism if the (negative) coefficient on the M/B ratio is below the sample median. An 3

6 increased takeover threat could put pressure on managers to boost current profits and cut long-term highrisk investments in innovation as a means to fend off takeover attempts. We find that firms with a higher likelihood of becoming a takeover target due to low stock valuation are associated with significantly more exploitative (fewer exploratory) patents than their lower likelihood peers. Using the classification scheme of Bushee (1998, 2001), we classify a public firm to be of high short-termism if the ratio of transient institutional ownership to total institutional ownership is above the sample median. A greater presence of transient institutional investors puts increased pressure on managers to focus on current profits and reduce long-term high-risk investments in innovation. We find that firms held by more short-term investors are associated with significantly more exploitative (fewer exploratory) patents than firms with fewer shortterm investors. We conclude that managerial short-termism driven by CEOs equity incentives, the market for corporate control, and the presence of transient institutional investors leads to less exploratory and more exploitative innovation. Our paper makes contribution to the literature in a number of dimensions. First, our comparison of innovative activities in public and private firms allows us to speak to big picture questions of important drivers of corporate innovation strategies sources of financing and managerial short-termism, which is the real distinction of our work from others. Previous investigations of the issues have largely ignored innovation strategies and different organizational learning trajectories and have been primarily limited to using public firms only. We show that on the extensive margin when the effects of the financing channel dominate, public firm status is associated with more innovation and patent counts. On the intensive margin when the effects of the managerial short-termism channel dominate, public firm status is associated with fewer exploratory patents. Since it takes exploration to survive and thrive through technological innovation waves in the long run (McGrath, 2001; Lavie, Stettner, and Tushman, 2010), our empirical evidence highlights the real effects of sources of financing and managerial short-termism. Second, this is one of the first studies providing large sample evidence on the innovative activities of privately-held US firms. Most studies to-date on private firm innovation employ only a small sample of transitioning firms such as LBO target firms or IPO firms (Lerner, Sørensen, and Strömberg, 2011; Bernstein, 2012; Aggarwal and Hsu, 2013) or a sample of startup firms (Barrot, 2012). In contemporaneous work, Acharya and Xu (2013) examine the relation between firms dependence on external capital and innovation output patent and citation counts using a large sample of public and 4

7 private firms. Different from their work, we focus on innovation strategies exploratory versus exploitative innovation. Finally, our study also adds to the management literature by highlighting the implications of public market listing on corporate innovation strategies. Prior studies have shown that firms are more (less) likely to engage in exploitative (exploratory) innovation when their shareholders/managers are myopic or risk-averse (Levinthal and March, 1993; Smith and Tushman, 2005), 1 when they pursue economies of scale (Crossan, Lane, and White, 1999), when their innovative activities are more likely to be subjects of imitation (Cohen and Levinthal, 1994), or when their environment appears to be less volatile (McGrath, 2001). The findings from our study suggest that the public market listing status of a firm should be part of its long-term planning on the trajectories of organizational learning and the evolutions of its competitive advantages. The paper is organized as follows. Section 2 reviews the related literature and develops our hypotheses. Section 3 describes our sample and key variable construction. Section 4 presents the main empirical analysis. Sample selection issues are addressed in Section 5. Additional investigation of the underlying forces behind managerial short-termism is implemented in Section 6. We conclude in Section Literature Review and Hypothesis Development There is a substantial literature examining the determinants of corporate investment in R&D and innovation. For our purpose, we mainly review papers directly related to our empirical investigation, namely the roles of financing and managerial short-termism, then proceed to develop our hypotheses Related Literature Our paper is related to the large literature establishing that financial development is associated with long-term economic growth and technological progress (see, for example, Schumpeter, 1934; 1 Levinthal and March (1993) build a conceptual framework of organizational learning and argue that managerial myopia leads to over-exploitation and under-exploration due to ignorance of the long run, the big picture, and the failure. 5

8 Levine, 2005; Hall and Lerner, 2010 for excellent reviews). However, less is known about how different financing choices equity versus debt and public versus private equity affect corporate innovation. Using a signaling model, Bhattacharya and Ritter (1983) show that innovative firms may lose their informational advantage if they disclose details of their R&D projects to capital markets in order to raise financing at better terms. Incorporating similar trade-offs, Maksimovic and Pichler (2001) further demonstrate that both technological and competitive risks affect the timing of private and initial public offerings in new industries: Early private financing occurs in risky industries with high development costs and low competitive risk, while early public financing occurs in viable industries with low development costs and low competitive risk. Empirically, there is mixed evidence on the effect of debt versus equity financing on innovation. On the one hand, Atanassov, Nanda, and Seru (2007) argue that banks do not have the ability to evaluate novel technologies and hence tend to discourage investing in innovative projects and be more prone to shut down ones that are on-going, and show that public firms that rely more on arm s length financing (equity and public debt) than on relational bank financing innovate more. Brown et al. (2009) find that supply shifts in external equity financing can explain a significant portion of the 1990s R&D boom and decline, especially among young firms that are most likely to be financially constrained. Nanda and Rhodes-Kropf (2011, 2013) illustrate both theoretically and empirically that hot financial markets encourage investors to engage in risky experimentation by funding innovative ideas because they expect these innovative activities to have a higher chance of receiving subsequent funding. In a cross-country study, Hsu, Tian, and Xu (2014) find that more developed equity markets encourage innovation in hightech industries while more developed debt markets discourage innovation in those industries. On the other hand, a number of recent empirical studies suggest that increased credit supply is beneficial to innovation, especially in small entrepreneurial firms. Using Italian data in the 1990s, Benfratello, Schiantarelli, and Sembenelli (2008) show a positive and significant effect of banking development on the probability of local firms introducing process or product innovation. Kerr and Nanda (2009) find that US banking deregulations brought about exceptional growth in both entrepreneurship and business closures. Using the World Bank Enterprise Surveys database, Ayyagari, Demirgüç-Kunt, and Maksimovic (2011) show that access to bank financing is associated with greater firm innovation for small and medium enterprises around the developing world. Using US data, Amore, Schneider, and Žaldokas (2013) show that interstate 6

9 banking deregulation had significant beneficial effects on corporate innovation of public firms, and Chava, Oettl, Subramanian, and Subramanian (2013) show the same effect on innovation of young private firms. It is worth noting that Chava et al. study is based on state-level innovation output by private firms without knowing their identities and basic financials. Focusing on public equity financing, Maug (1998), Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011) argue that stock liquidity facilitates the entry of monitoring blockholders and/or blockholders gathering and trading on private information which makes stock prices more informative. If high liquidity leads to better monitoring and/or more efficient prices, managers may be willing to forego short-term profits to invest in long-term projects such as innovation. On the other hand, Ferreira, Manso, and Silva (2012) point out that private firms are less transparent to outside investors than are public firms, leading to the tolerance-for-failure effect as the key determinant of exploratory innovation in private firms. Longer investment horizon of private firm shareholders reinforces the positive effect of low transparency on exploratory innovation. In contrast, the rapid incorporation of good news into market prices creates incentives for short-termism behavior by public firms including pursuing exploitative innovation. They predict that it is optimal to go public to exploit existing ideas and optimal to stay private to explore new ideas. Fang et al. (2013) show that an increase in liquidity is associated with a reduction in corporate innovation. Acharya and Xu (2013) find that public listing is beneficial to the innovation of firms in industries with a greater need for external capital. The mixed evidence on the role of financing in corporate innovation thus calls for further investigation. Our paper is also related to the literature on managerial short-termism and corporate investment. In Stein (1988), there is greater information asymmetry for long-term investments than for short-term investments and there are takeover threats. If a takeover occurs before the payoff of long-term projects is known, target shareholders will receive an undervalued price that does not reflect the true value of the firm. To protect shareholders from this potential wealth loss, managers of undervalued firms attempt to boost the firms current earnings by cutting long-term investments that the market cannot value accurately, leading to managerial short-termism. Bebchuk and Stole (1993) further show that a combination of information asymmetry on the level of investment undertaken and managers caring for short-run performance could also lead to under-investment in long-run projects. Bolton, Scheinkman, and Xiong (2006) show that allowing for heterogeneous beliefs by investors and consequently speculative 7

10 deviations of stock prices from fundamentals create a distortion in CEO compensation leading to a shortterm orientation. Empirically, there is mixed evidence on the role of takeover markets in corporate innovation. Atanassov (2013) shows that strong corporate governance proxied by the threat of hostile takeovers positively affects innovation and firm value. Sapra, Subramanian, and Subramanian (2013) find that innovation varies non-monotonically in a U-shape manner with the takeover pressure faced by firms: Innovation is fostered either by an unhindered market for corporate control or by anti-takeover laws that effectively deter takeovers. On the other hand, Meulbroek, Mitchell, Mulherin, Netter, and Poulsen (1990) show that after introducing anti-takeover amendments, firms do not significantly increase their R&D expenditures. One challenge of testing these myopia models is the lack of a clean measure for managerial shorttermism. A number of recent papers have made progress in this direction. Using the sensitivity of a CEO s stock and option grants that are scheduled to vest over the coming year to proxy for her myopic tendencies, Edmans, Fang, and Lewellen (2014) find that managerial short-termism leads to reductions in real investments including R&D, capital expenditures, and advertising expenses. Ladika and Sautner (2014) show that FAS 123R induces firms to accelerate the vesting period of option grants, and such accelerated vesting leads to a reduction in capital expenditures. Our paper is complementary in that we rely on the dichotomy between public and private firms to capture managerial short-termism and to investigate the link between managers short-term focus and innovation strategies. We also explore the underlying driving forces behind managerial short-termism Hypothesis Development Being publicly-listed versus privately-held are associated with a number of important differences that could potentially impact corporate innovation strategies. Under the financing perspective, private firms are subject to more financing frictions than public firms and they rely mainly on debt financing (Brav, 2009; Gao, Harford, and Li, 2013), which typically does not encourage innovative behavior (Atanassov, Nanda, and Seru, 2007). Better access to funding also generates financial slack that protects firms from uncertainty associated with innovative activities and thus fosters a culture of experimentation 8

11 (Nohria and Gulati, 1996). Levinthal and March (1993) note that the costs to exploiting activities are lower than those to exploring activities. Public firms stocks are freely traded, allowing public firm shareholders to achieve better portfolio diversification and risk-sharing, which in turn encourages more corporate risk-taking (King and Levine, 1993; Faccio, Marchica, and Mura, 2011). Moreover, risk management tools (such as derivatives) available in public equity markets allow investors to make more efficient portfolio allocation and to pursue high risk-high return projects (Levine, 2005). The above discussions suggest that public firms with better access to financing and their shareholders with better risk-sharing tools are more likely to invest in innovation and engage in long-term high-risk exploratory innovation, leading to our first hypothesis regarding innovation strategies in public and private firms: The Financing Hypothesis: Public firms innovation is more exploratory (less exploitative) than private firms innovation. Under the managerial short-termism perspective, we expect that managers in public firm are faced with greater short-term performance pressure than their counterparts in private firms for a number of reasons. First, public firm managers can easily sell their equity holdings in the stock market (upon vesting). Their ability of taking advantage of short-term price fluctuations to profit from equity sales encourages these managers to pursue short-term projects at the expense of high long-term fundamental values (Bolton et al., 2006; Edmans et al., 2013; Gopalan, Milbourn, Song, and Thakor, 2014). In contrast, private firm managers have to hold their equity stakes for a long period of time and have much more limited ways to cash out because of their non-publicly-traded stock. Second, while a temporary undervaluation may increase the likelihood for a public firm to be taken over at an unfavorable price (Stein, 1988), private firms are faced with very little threat of hostile takeovers due to their non-publiclytraded stock. Lastly, short-term shareholders in public firms tend to put pressure on managers to sacrifice long-term investments in order to meet short-term earnings targets (Bushee, 1998). Such short-term pressure is much weaker in private firms because the lack of stock liquidity forces private firm shareholders to take a long investment horizon (Ferreira et al., 2012). Given that exploitative innovation results in immediate performance (Levinthal and March, 1993), we expect that public firms choose to focus on exploitative innovation over exploratory innovation. The above discussions lead to our alternative hypothesis: 9

12 The Short-Termism Hypothesis: Public firms innovation is more exploitative (less exploratory) than private firms innovation. Our empirical analysis is designed to test these two hypotheses that have opposite predictions on innovation strategies in public and private firms, and also to explore alternative explanations for why innovation strategies differ between public and private firms. In the next section we describe our sample and key variable construction, and present descriptive statistics. 3. Sample Formation and Variable Construction Our primary data sources are the Capital IQ database, the National Bureau of Economic Research (NBER) Patent Citations Date File (Hall, Jaffe, and Trajtenberg, 2005a, 2010 update), and the Harvard Business School (HBS) US Patent Inventor Database (Lai, D Amour, Yu, and Fleming, 2011). 2 Capital IQ is an affiliate of Standard & Poor s that produces the Compustat database. 3 We start with a list of unique non-financial US firms covered in Capital IQ for the period Our sample starts in 1997 because the data coverage in Capital IQ is poor before 1995 and we employ a lead-lag specification and a three-year window to measure innovation strategies, and ends in 2008 because the patent information from the HBS database is available till 2010 but there is a wellknown two to three year lag between patent application and award dates (Hall et al., 2005a). We obtain the patent and citation data for these firms by manually matching the NBER and HBS patent databases 2 The HBS patent database is constructed in a similar manner as the NBER patent database, and has more recent patent data (and more details about patent inventors). There are a number of important differences between the HBS patent database and the NBER patent database. First, the HBS patent database is not matched to Compustat, while the NBER patent database is. Second, the HBS patent database has scant coverage of PDPASS (the NBER assignee identifier) for the period While 84.6% of awarded patents carry PDPASS in the NBER patent database in all years, the ratios of awarded patents with PDPASS in the HBS database are 67%, 65%, 62%, and 0% in 2007, 2008, 2009, and 2010, respectively. Based on both algorithm and manual matching, we are able to obtain PDPASS for 82.4% of awarded patents in the HBS database for the period The Capital IQ data on private US firms is based on the following mandatory disclosure requirements by the Securities and Exchange Commission (SEC). First, if a company decides on a registered public offering, the Securities Act requires it to file a registration statement (Form S-1) with the SEC that contains basic financial information. Second, and more applicable to our sample of privately-held firms, even if a company has not registered a securities offering, it must file an Exchange Act registration statement if it has more than $10 million in total assets and a class of equity securities, like common stock, with 500 or more shareholders. After that, the company is required to continue reporting via annual and quarterly reports and proxy statements. Capital IQ provides accounting information on private US firms with a similar level of details as provided by Compustat on public US firms. 10

13 (by first assignee name and then location) with the list of unique firms in the Capital IQ database. We end up with an initial sample of 53,055 public firm-year observations and 148,852 private firm-year observations. We further require all sample firm-year observations with basic financial information. To mitigate the reverse causality concern that innovation strategies drive going public/ private decisions (rather than the public/private status drives innovation strategies), we remove firm-year observations associated with going-public (1,341 IPOs) or going-private transactions (92 deals). In other words, our sample private firms always stay private and our sample public firms always stay public. 4 Public firms are those traded on the NYSE, AMEX, or NASDAQ. The full sample consists of 50,294 public firm-year observations (9,163 unique public firms) and 16,217 private firm-year observations (6,549 unique private firms) for the period The top five public firm industries are: Business Service (17.2%), Pharmaceutical Products (6.9%), Retail (6.2%), Electronic Equipment (5.7%), and Wholesale (4.9%). The top five private firm industries are: Business Service (15.7%), Utility (12.5%), Wholesale (7.9%), Communication (6.7%), and Retail (4.6%). Our focus is on corporate innovation strategy, so we need to examine a sample of innovative firms (i.e., firms with patents), similar to Akcigit and Kerr (2012), Bloom, Schankerman, and Van Reenen (2013), and Aghion, Van Reenen, and Zingales (2013). Innovative firms in year t are identified as firms filing at least one patent over the three-year period from year t-2 to year t during the sample period The innovative firm sample consists of 13,463 public firm-year observations representing 2,426 unique public firms and 1,729 private firm-year observations representing 829 unique private firms for the period Measures of Innovation Strategy Exploratory versus exploitative patents Our measures of innovation strategy exploratory and exploitative patents come from the management literature. Following Benner and Tushman (2002), we use a firm s existing expertise the 4 It is worth noting that including those going-public/going-private firms in our analyses does not change our main findings. Further, those going-public firms will be used in our identification tests later on. 11

14 combination of its portfolio of patents and citations made by its existing patents over the past five years to characterize the nature of its innovative effort. Exploratory innovation goes beyond the existing expertise, while exploitative innovation deepens the existing expertise. A patent is categorized as exploratory if 60% (80%) or more of its citations are based on new knowledge outside of a firm s existing expertise (i.e., not citing the firm s existing patents or the citations made by those patents); while a patent is categorized as exploitative if 60% (80%) or more of its citations are based on a firm s existing expertise (i.e., the firm s existing patents and the citations made by those patents). At the firm level, the variable Explore60 (Explore80) in year t is the number of exploratory patents applied in year t-2 to year t divided by the total number of patents applied in the same three-year period. We use the application year (instead of the award year) to better capture the exact timing of the underlying innovative activities behind a patent. This variable ranges between zero and one, and a higher exploratory ratio suggests that a firm s innovation effort focuses on expanding its technological expertise by deviating from its current innovation trajectories and creating patents that may lead to new competitive advantages in totally different territories. At the firm level, the variable Exploit60 (Exploit80) in year t is the number of exploitative patents applied in year t-2 to year t divided by the total number of patents applied in the same three-year period. The exploitative ratio ranges between zero and one, and a higher exploitative ratio suggests that a firm s innovation effort focuses on deepening its technological expertise by following its current innovation trajectories and developing patents that extend its competitive advantages in existing territories. For a robustness check, we also employ two related alternative measures to capture the nature of innovation, following Katila and Ahuja (2002): innovation scope and depth. Innovation scope intends to capture the frequency a firm acquires new knowledge outside of its existing knowledge: The more often a firm has acquired new knowledge, the broader knowledge scope it has. A firm s existing knowledge consists of citations made by its existing patents over the past five years. Our first alternative measure, the variable Scope in year t is the number of new citations made by patents applied in year t-2 to year t divided by the total number of citations made by all patents applied in the same three-year period. New citations are citations that have never been made by the firm in the past five years. The scope variable 12

15 ranges between zero and one, and a higher value indicates that a firm acquires more new knowledge in building its patent portfolio and thus may have a better chance to achieve new competitive advantages. Innovation depth intends to capture a firm s repetitive application of its existing knowledge: The more often a firm has applied its existing knowledge, the more deeply it understands it. Our second alternative measure, the variable Depth in year t is the number of repeated citations made by patents applied in year t-2 to year t divided by the total number of citations made by all patents applied in the same three-year period. Repeated citations are citations that have been made by the firm in the past five years. The depth variable is equal to or greater than zero, 5 and a higher value indicates that a firm repetitively exploits its existing knowledge and thus may have a deeper understanding of its current technological territories. More detailed discussions on constructing Explore60, Explore80, Exploit60, Exploit80, Scope, and Depth are provided in Appendix Patent count Patent count is the number of awarded patents applied by firm i in year t-2 to year t. This measure has been widely used in the literature to capture the success of a firm s innovative activities since Scherer (1965) and Griliches (1981). We set this variable to zero for firm-year observations in the full sample without any patent record. This variable is always greater than zero in the innovative firm sample by construction. Assessment of the innovation output of a given firm using patent count can only be made relative to some benchmark for the following reasons. First, technology classes differ in the nature of R&D activities and resources required to produce patentable innovation such that patent counts in two different classes may not be directly comparable. Second, there are technology class-specific time trends in the number of awarded patents that may not fully reflect changes in innovation output. In particular, large increases in the number of awarded patents in some classes over time might reflect evolution of the US Patent and Trademark Office (USPTO) practices with respect to what is patentable innovation, and hence 5 The depth ratio could be above one because some current citations may have been made more than once in the past. For example, if a firm has only one patent that is filed in year t and only cites one prior patent, and if this citation has been made by two patents filed by the firm over the past five years, then the depth ratio is two for this firm in year t. 13

16 patent counts from different years may not be time-consistent measures of innovation output even within the same technology class. We address both issues by summing up scaled number of patents, where we divide the number of awarded patents in technology class k with application year t by the average number of awarded patents applied by both public and private firms in the same technology class and year, following Bena and Li (2012) and Seru (2014). Our adjusted patent count thus accounts for differences across technology classes and differences in the USPTO practices over time. More detailed discussions on constructing Patent count and Patent count CIQ are provided in Appendix 1. As a robustness check, we also employ the variable Citation count, capturing the impact of corporate innovation and its associated economic value (Trajtenberg, 1990; Hall, Jaffe, and Trajtenberg, 2005b; Aghion, Van Reenen, and Zingales, 2013). We need to make some adjustment for citation counts because patents continue to receive citations over a long period of time, while we observe at best only up to the last year of the available data (in our case the year of 2010). As a result, patents awarded in different years suffer to different extent from this truncation bias in the number of citations received, and their citation counts are not comparable and cannot be aggregated. Further, patents awarded in different technological classes are also cited in different ways, which needs to be accounted for before aggregating. We make adjustments to citation count following Hall, Jaffe, and Trajtenberg (2005a, henceforth HJT), Lerner, Sørensen, and Strömberg (2011), Bena and Li (2012), and Seru (2014). More detailed discussions on constructing Citation count and Citation count CIQ are provided in Appendix 1. In addition to these two flow measures of innovation output, we also employ a stock measure of a firm s patent portfolio, Patent stock, which is the total number of granted patents applied by firm i up to year t Summary Statistics Table 1 provides the temporal distribution of our sample. We show that there is a deceasing trend in the number of public firms over the sample period, while there is an increasing coverage by Capital IQ of private firms over the same period. About 30% of public firms have awarded patents, while only about a tenth of private firms have awarded patents. The univariate statistics are suggestive of public firms being more innovative than private firms. We further note that starting 2007 (2008), there is a decline in 14

17 the fraction of public (private) firms with awarded patents, probably because of the time lag for an applied patent to be eventually awarded. Table 2 provides summary statistics of our sample. Definitions of all variables are provided in Appendix 1. All dollar values are in 2008 dollars. All continuous variables are winsorized at the 1 st and 99 th percentiles. Panel A compares innovation measures and firm characteristics between public and private firms in the full sample. We first show that public firms are more innovative in terms of innovation output (Patent count). On average, public firms produce patents per three-year period, while private firms produce 2.28 patents per three-year period. Similarly, the mean patent count (adjusted by CIQ firm averages, Patent count CIQ ) for public firms is 3.48, while the mean for private firms is The two-sample tests of differences (i.e., the t-test and Wilcoxon-test) reject the null that public and private firms have the same level of innovation output at the 1% level. The mean HJT-adjusted citation counts (Citation count) show that on average, public firms patents receive a total of citations over their life time, while private firms patents receive 6.63 total citations. Once we limit the window to count citations to the award year and subsequent three years, the mean citation count (adjusted by CIQ firm averages, Citation count CIQ ) for public firms patents is 15.05, while the mean for private firms patents is The difference is statistically significant at the 1% level in both the t-test and Wilcoxon test, rejecting the null that public and private firms have the same level of innovation output. On average, public firms have a total of patents (Patent stock), while private firms have a total of patents. The difference is statistically significant at the 1% level in both the t-test and Wilcoxon test, rejecting the null that public and private firms have the same number of patent stock. In terms of comparing firm characteristics between public and private firms, 6 we show that public firms are significantly larger than private firms. Further, we show that on average, public firms have significantly lower leverage than private firms, consistent with the general belief that public firms have better access to equity financing and thus rely less on debt financing. Finally, public firms have significantly faster sales growth, higher capital expenditures, and are significantly older than private firms; while private firms 6 Note that none of the correlations among firm characteristics is high enough to warrant multi-collinearity concerns for our multivariate analyses. 15

18 have significantly higher fixed assets as measured by property, plant and equipment (PPE) than public firms. Importantly, public firms spend significantly more on R&D than private firms. Panel B compares innovation measures and firm characteristics between public and private firms in the innovative firm sample. Again in this comparison, we show that public firms have significantly more patent counts, citation counts, and patent stock than private firms, which is consistent with findings in Acharya and Xu (2013). New in this panel, we examine innovation strategies in public and private firms. We show that on average, using the variable Explore60 (Explore80), 51% (48%) of public firms patents are exploratory, while 60% (58%) of private firms patents are exploratory. Such a difference is both economically important (representing about a 15% drop in exploratory patents when firms change listing status from private to public) and statistically significant at the 1% level, suggesting that private firms focus more on exploring new technological territories than public firms do. In contrast, using the variable Exploit60 (Exploit80), 14% (12%) of public firms patents are exploitative, while 10% (9%) of private firms patents are exploitative. Again such a difference is both economically important (representing about a 25% increase in exploitative patents when firms change listing status from private to public) and statistically significant at the 1% level, indicating that public firms innovation is more exploitative than private firms. Comparing innovation scope and depth between public and private firms, we find that the average scope (depth) for public firms is 0.75 (0.21), while the average scope (depth) in private firms is 0.81 (0.12). These differences are also significant at the 1% level, indicating that public firms innovations tend to rely more on the existing knowledge (i.e., more exploitative) but private firms innovations tend to go beyond the existing knowledge domain (i.e., more exploratory). Overall, the summary statistics in this panel provide some support for the short-termism hypothesis that public ownership is associated with more exploitative innovation and less exploratory innovation. In terms of comparing firm characteristics between innovative public and private firms, we show that in addition to the differences we have shown before between public and private firms in general, innovative public firms have significantly better operating performance than innovative private firms, while both groups of innovative firms have similar sales growth. Next we employ multivariate analysis to test our hypotheses. 16

19 4. Main Results 4.1. Exploratory versus Exploitative Innovation So far, we have shown that public firms on average are more innovative than private firms in terms of innovation output, it is premature to rave about public ownership given that there are many more private firms than public firms contributing significantly to the US economy (Asker, Farre-Mensa, and Ljungqvist, 2013). We need to take a careful look at these two groups of firms innovation strategies as captured by the exploitative versus exploratory nature of innovation. To empirically test our two hypotheses, we run the following panel data regression (for brevity, we omit firm subscript i and time subscript t, and t is from 1997 to 2008): &, (1) where denotes one of the four measures for innovation strategies Explore60, Explore80, Exploit60, and Exploit80 of firm i in year t (which is computed using patent information over the three-year period from year t-2 to year t). Public is an indicator variable that takes the value of one if firm i is a public firm in year t, and zero otherwise. We include the following set of explanatory variables; all firm financials are measured in year t-2. is the logarithm of the total number of granted patents owned by firm i at the end of year t-3 and it controls for the size of a firm s patent portfolio and existing knowledge; is the logarithm of total assets of firm i controlling the effect of firm size on innovation strategies; is the ratio of total debt to total assets controlling for the effect of financial leverage on innovation strategies; is return on assets capturing the influence of profitability on innovation strategies; is the growth rate of sales controlling for business prospects and growth opportunities; is the ratio of capital expenditures to total assets capturing the effect of physical investments on innovation strategies; & is the ratio of R&D expenditures to total assets capturing the effect of intangible investments on innovation strategies; is the ratio of net property, plant, and equipment to total assets controlling for asset tangibility; and 17

20 is the logarithm of firm i s vintage capturing the effects of firm life cycle and information asymmetry on innovation strategies. We also include industry times year fixed effects to control for unobserved industry- and yearspecific heterogeneity such as competitive pressure and industry-specific business cycles. Industries are based on Fama and French s (1997) 48 industry classification. We do not include firm fixed effects because our main variable of interest,, largely overlaps with firm fixed effects. 7 The coefficient on the Public indicator variable thus measures the difference in innovation strategies between public and private firms that cannot be accounted for by differences in firm characteristics and industry and year fixed effects. Table 3 presents the regression results based on Equation (1). Our statistical inferences are based on standard errors clustered at the firm level that correct for time-series correlation in firm-level innovation strategies, if any. Panel A employs the innovative firm sample. Columns (1) and (2) compare public and private firms in the exploratory nature of innovation. We show that the coefficients on the Public indicator variable are negative and significant at the 1% level. In terms of the economic significance, an average public firm produces 5%-6% fewer exploratory patents than an average private firm, consistent with the short-termism hypothesis. This suggests that private firms are more likely to go outside of the existing expertise in their innovation effort. We also show that patent stock is negatively associated with exploratory patents. This is not surprising as firms with bigger patent portfolios, ceteris paribus, have larger pools of existing knowledge (their own patents or past citations) for them to exploit and are thus less likely to cite outside their existing knowledge. We further show that large firms and firms with good operating performance are associated with more exploratory patents. Interestingly, we do not find any significant association between R&D and exploratory innovation. 8 Lastly, we show that older firms tend to produce more exploratory patents. These results suggest that larger and older firms tend to reinvent themselves to explore new technological territories. 7 In our main analysis involving the innovative firm sample, all sample firms remain either public or private throughout the sample period. Nonetheless, when we conduct similar analysis using a sample of IPOs with firm fixed effects, we obtain consistent results. 8 This finding is, however, consistent with the literature that higher R&D expenditures do not necessarily lead to more innovation. Jaffe (2000) and Lanjouw and Schankerman (2004) report that the surge of R&D investment since the 1980s does not generate commensurate patents. The Economist (1990) also notes that American industry went on an R&D spending spree, with few big successes to show for it. 18