Corporate Governance and Innovation: Theory and Evidence

We develop a theory of the e¤ects of external corporate governance mechanisms — such as takeover pressure — and internal mechanisms — such as compensation contracts and monitoring intensity — on innovation. Our theory generates the following testable predictions: (i) innovation varies non-monotonically in a U-shaped manner with takeover pressure; (ii) innovation increases with monitoring intensity; and (iii) the sensitivity of innovation to changes in takeover pressure declines with monitoring intensity. We show strong empirical support for these predictions using both ex ante and ex post measures of innovation. We use cross-sectional and time-series di¤erence-in-di¤erence tests to identify the causal e¤ects of governance mechanisms on innovation. Our study suggests that innovation is fostered by either an unhindered market for corporate control or strong anti-takeover laws that signi…cantly deter takeovers. An unhindered market for corporate control fosters innovation through the incentives provided by takeover premia that increase with the degree of innovation. Severe anti-takeover laws may, however, also encourage innovation ex ante by reducing the likelihood of ex post private control bene…t losses. The interplay between the relative magnitudes of these con‡icting forces causes innovation to vary non-monotonically with takeover pressure. JEL: G31, G34, K22 Keywords: Anti-takeover laws, Blockholders, Corporate Governance, Innovation, External Governance, Internal Governance, Monitoring, Takeovers. We thank Ningzhong Li for excellent research assistance. Haresh Sapra and Ajay Subramanian are grateful to the University of Chicago Graduate School of Business and the J. Mack Robinson College of Business, respectively, for …nancial support. Krishnamurthy Subramanian thanks the Kau¤man Foundation for …nancial support related to this project. The usual disclaimers apply.