Do Cashflow Performance Metrics Incentivize CEOs to be Better Innovators?

Building on prior research that postulates a positive relationship between firms’ cash flow and innovation output, we examine whether the use of cashflow performance metrics in CEOs’ compensation contracts has a positive effect on firms’ innovation output. We hypothesize and find that firms using cashflow performance metrics in CEOs’ incentive contracts show higher innovation output and higher product market pricing power; in addition, the higher innovation output is accomplished through higher innovation efficiency rather than higher innovation input. The incentive effect of cashflow metrics exists in both cash grants and equity grants. Further, we find that the incentive effect is stronger when firms receive higher coverage by market intermediaries, when cash flows are more likely to contain information not found in earnings, and when earnings are more likely to be managed. Our findings are consistent with the usefulness of cashflow performance metrics in incentivizing management to pursue high-quality firm innovation