NEW YORK – For decades, corporate executives and their boards of directors have managed companies to prioritize short-term profitability, making decisions and structuring operations to produce consistent quarterly profits and drive up stock values. Previous research supports the theory that the pressure to regularly perform in capital markets corresponds to long-term growth and improved innovation, and more recent studies argue that state laws that restrict hostile takeovers result in companies stagnating. But Columbia Business School Professor Daniel Keum argues that companies and policymakers should reevaluate short-termism and instead allow managers the flexibility to invest in innovative approaches that can produce new products. In a new study, Innovation, Short‐termism, and the Cost of Strong Corporate Governance, Keum finds that the outside threat of hostile takeovers and the relentless pressure on corporate leadership to prioritize earnings can stifle research and development.
"Shareholder primacy dominates how businesses function in the United States, but what’s becoming clear is that companies that are under intense pressure to perform on the market will underinvest in innovation," said Columbia Business School Assistant Professor of Management Daniel Keum. "Private equity firms and hedge funds that take control of companies and overhaul operations have short windows of involvement, but their impact is often permanent. So as companies stop experimenting on how to make their products more effective or how to strengthen their operations, policymakers must consider that these takeovers can stifle innovation."
In the new research, published in the Strategic Management Journal, Keum focuses on the impact of business combination laws, implemented state-by-state to restrict institutional investors from pursuing takeovers. Private equity firms and hedge funds, in particular, carry out hostile takeovers of companies and install management who refocus company priorities solely on short-term profitability – a strong governance approach to management. The possibility of a takeover alone can drive corporate executives to increase their focus on quarterly earnings to deter institutional investors from targeting their companies. Although the laws against takeovers can weaken governance and permit managers to spend more freely, Keum finds that this necessary evil allows managers to experiment and innovate – with positive spillover to the broader economy.
In the new research, Keum revisits two earlier studies that reject the idea that short-termism can stifle innovation and defend the positive role of both the capital market and institutional investors. To replicate the earlier analyses, Keum looks at all public companies from 1976 to 2000, developing a sample of more than 4,000 companies and matching their annual patent applications with the United States Patent and Trademark Office. He then analyzes the influence of different factors, including the presence of business combination laws in a firm’s state of incorporation and the percentage of institutional ownership.
Additional key findings include:
Removing Hostility: Laws that prevent hostile takeovers have a positive impact – states that have laws insulating companies from hostile takeovers see patent counts increase 2.8 percent, citation counts increase 5.2 percent, and the market value of patents increase 6.2 percent.
Factoring in the competition: The presence of institutional ownership and the level of competition from other products in the market both have a stronger impact on how oversight affects innovation and can account for some of the inconsistencies in current empirical governance research.
Moving cautiously on strong oversight: The study’s findings have important implications for the movement to mandate strong corporate governance, especially because an increasing share of public firms are now owned by transient institutional investors.
"A relentless focus on earnings comes at a cost to our economy when companies hold back from investments in research and development," Keum said. "At a time when both of the Democratic and Republican presidential candidates have discussed the need to remove the pressure of quarterly earnings reports, it’s important that policymakers consider the need to relax this ongoing restraint on corporate executives so that companies can take steps to create greater long-term value, especially through investment in innovation."
To learn more about the cutting-edge research being conducted at Columbia Business School, please visit www.gsb.columbia.edu.
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