Corporate Governance and Innovation: Theory and Evidence

Abstract

We develop a theory to show how external corporate governance mechanisms, such as the market for corporate control, and internal governance mechanisms interact to affect innovation by …firms. Our model generates the novel testable implication that there is a non-monotonic U-shaped relation between the degree of innovation undertaken by …firms and the external takeover pressure they face. The U-shaped relation arises from the incentive effects of the interaction between expected takeover premia and private bene…fits of control both of which vary with the takeover pressure that the …firm faces. In particular, the key characteristics of innovation that distinguish it from mere risk-taking play a central role in generating the U-shaped relation.

We show strong empirical support for the predicted non-monotonic relation using both ex ante and ex post measures of innovation. Our empirical analysis exploits the cross-sectional as well as time-series variation in takeover pressure created by the sequential passage of anti-takeover laws across different states. Our results suggest that innovation is fostered either by an unhindered market for corporate control, or by anti-takeover laws that are severe enough to effectively deter takeovers.

Keywords: Anti-takeover laws, Blockholders, Corporate Governance, Innovation, External Governance, Internal Governance, Monitoring, Takeovers

JEL Classification: G31, G34, K22