Venture-Capitalist Directors and Managerial Incentives

Research has shown that venture capital (VC) firms substantially influence the overall economy. According to Gornall and Strebulaev (2021), among all U.S. public companies founded since 1968, VC-backed companies account for 77 percent of total market capitalization, 41 percent of total employees, and 92 percent of R&D spending. In addition, there is extensive literature discussing the role of VC firms at startup companies, where they do everything from providing advice and support to improving corporate governance to fostering corporate innovation. However, there is limited understanding about the role of VC at mature companies, especially VC’s impact on executive compensation.

Research has also shown that powerful incentives like restricted stock grants and other performance-based executive compensation have increased considerably in the last three decades. That increase has prompted a significant rise in the sensitivity of CEO wealth to stock price, i.e., delta, and in the sensitivity of CEO wealth to stock price volatility, i.e., vega.

In a new paper, we study whether the presence of board members with concurrent VC experience (hereafter, VC directors) in publicly listed companies affects the use of performance-based compensation. We hypothesize that the appointment of VC directors is associated with stronger pay-risk (vega) and stronger pay-performance (delta) sensitivities. We find support for this hypothesis using executive compensation data from 1998 through 2018.

We define a VC director as a director who has concurrent VC experience, i.e., becomes employed by a VC firm before appointment as director in the public firm of interest. Our results show that putting VC directors on compensation committees is associated with greater CEO vega and greater CEO delta after controlling for a series of factors. However, we do not find similar effects when VC directors are on other board committees (i.e., governance-, audit-, or nomination-committee). Using the Lee-Pollock-Jin (2011) VC reputation index, we also document that these effects are more substantial if VC directors are from highly reputable VC firms. Other cross-sectional analysis shows that these effects are more pronounced if firms have more robust governance, higher institutional ownership, a smaller gap between the amounts paid the CEO and other employees, fewer business segments, or a lower percentage of independent board members.

To explore how VC directors influence CEO incentives, we investigate the goals of CEO performance metrics on which annual CEO incentive awards are based. Using sales-growth goals and earnings goals as proxies for growth and profitability, respectively, we find that VC directors are more likely to emphasize growth rather than profitability performance goals. This finding is consistent with Puri and Zarutskie (2011), who show that the vital firm characteristic on which VC focuses is scale or potential for scale, rather than short-term profitability. We also document that VC directors more frequently use absolute rather than relative performance goals.

We use two approaches to mitigate the possible effects of endogenous factors. First, we use the 2009 amendment to Regulation S-K to test whether VC expertise on a compensation committee affects managerial incentives through compensation contracts. The 2009 Amendment to Regulation S-K requires U.S. public firms to describe their reasons for nominating directors in the proxy statement. The justification for the requirement is that the qualifications and experience of individual directors matter, which in turn may have increased the demand for qualified directors such as VC directors. We find that our results are robust to this potential selection bias. Second, we use matched sample analysis to determine whether firms with VC directors have higher CEO vega and delta than firms without VC directors. The treatment group is defined as (i) firms with VC director(s) on the board or (ii) firms with VC director(s) on the compensation committee. The control firms are matched by size, industry, and year. The results are consistent with our baseline results.

Our findings align with Celikyurt, Sevilir, and Shivdasani (2014), who show that firms with VC director(s) do more research and development, are more innovative and engage in more deals with other VC-backed firms. They argue that the innovation skills of VC directors allow boards to assess better the merits of increasing research and set the appropriate strategic priorities for such initiatives. Consistent with this result, we show that one possible way directors promote corporate innovation is through incentives for CEOs to take risks. Our results hold for innovation inputs, measured by the amount of R&D, and innovation outputs, measured by the number of patents and patent citations and patent value (Kogan et al., 2017).

In addition, we examine the impact of VC directors on forced CEO turnover. We find that having one or more VC directors on the nomination or governance committee is associated with a higher likelihood of forced CEO turnover if firms’ stock prices drop. This is consistent with Hochberg (2012), who documents that VC firms facilitate good corporate governance, and we add new evidence that such an effect not only operates among VC-backed IPOs but also publicly-listed mature companies.

Our paper reexamines the advisory roles of VC directors in public firms to uncover how such directors affect executive compensation. We contribute to the literature in three ways. First, using more recent data on executive compensation, our research examines the role of VC directors in strategic decision-making in listed firms. In particular, our research explores how directors with VC experience use compensation to increase corporate risk-taking. It complements the literature on how the characteristics of independent directors influence executive compensation contracts. Second, our findings contribute to understanding the relationship between boards of directors’ expertise and executive compensation. More precisely, we discuss the differences in setting performance goals when VC directors are involved with the compensation committee and show that they emphasize growth at the expense of profitability or stock price. Third, we provide evidence to support Celikyurt et al. (2014), who suggest that VC directors improve executive incentives to innovate by changing the design of top management compensation schemes and increasing CEO monitoring, resulting in greater CEO turnover following weak shareholder returns.

This post comes to us from Lubomir P. Litov, a professor at the University of Oklahoma’s Michael F. Price College of Business; Xia (Summer) Liu, a Ph.D. candidate at the University of Oklahoma’s Michael F. Price College of Business; William L. Megginson, a professor at the University of Oklahoma’s Michael F. Price College of Business; and Romora E. Sitorus at the Indonesian Ministry for Economic Affairs. It is based on their recent paper, “Venture Capitalist Directors and Managerial Incentives,” available here.