In an interview, when teased about his reckless, highly innovative and risky investments, Elon Musk replied ‘it's OK to have your eggs in one basket as long as you control what happens to that basket.…The problem with the Silicon Valley financing model is that you lose control after the first investment round.’ Although Musk’s view indicates significant benefits of maintaining control over a firm’s investments, the existing economic literature has failed to provide unambiguous evidence on the relationship between corporate governance and firm innovation.
Following Coase (1937), some scholars emphasize the benefits of control when contracts are incomplete and subject to hold-up risks. Because large shareholders commit to assets, as well as to long-term value creation, by collecting information, monitoring and exerting pressure on the management, they stimulate firm innovation. On the other hand, using arguments based on risk-diversification and market pressure, other lines of research claim that de-concentrated corporate ownership structures – like publicly traded corporations – with centralized management should correlate with higher levels of innovation. Being the outcome of an innovative project inherently uncertain, a single entrepreneur, unwilling to bear all the risk, may be reluctant or unable to finance it entirely. Risk-averse innovators, therefore, may prefer relinquishing firm control to share the risk of innovation with other small shareholders. Shareholder-driven corporate ownership structures, moreover, should reduce the room for managerial opportunism, as the stock market pressure increases directors’ accountability and discourages rent-seeking behaviour (eg, Bebchuk and Cohen (2005)).
With such mixed and contrasting predictions, which of the two views prevails in the debate remains an empirical question. In a recent paper, using a sample containing annual data from about 150 Swiss companies over the 1990-2010 period, Marcello Puca and I conducted a causality test of the relation between the ownership concentration of firms and their innovation, measured by patents and patent citations.
In this respect, Switzerland is an interesting case study. First, according to the Global Innovation Index, Switzerland stands out as the most innovative country in the world and has the highest average number of patent applications over GDP among the most developed countries during the 1990-2010 period. Second, Switzerland has the highest market capitalization as a percentage of GDP among advanced economies—this is in contrast with the ‘legal origin’ perspective, which predicts that a civil-law country like Switzerland should lack a well-developed financial market (on the Swiss exception, see also Vatiero (2017) or this blog). Another advantage of focusing on Switzerland is the opportunity to address endogeneity concerns arising when considering corporate governance structures and firm innovation.
Using the introduction of the takeover legislation in the 1998 Swiss Stock Exchanges and Securities Trading Act (‘SESTA’) as a source of exogenous change in ownership concentration, we find that, in line with the view based on the hold-up and incomplete contracts arguments, concentrated ownership spurs innovation. While we document a negative cross-sectional relation between ownership concentration and innovation, the relation becomes positive when we consider the time-series dimension, suggesting that the effect of concentrated ownership on innovation appears only in the medium-term.
We also find that, quite surprisingly, innovation is negatively associated with future firm value. There are many possible interpretations for this puzzling result. Our interpretation is that, since we find firms with concentrated ownership innovating more, the returns of innovation, at least partially, may become private benefits of concentrated owners (ie, large shareholders). This is in line with the view which considers innovation as an instrument used by controlling shareholders to create and maintain private rents, rather than maximizing firm value (Boldrin and Levine (2008)).
Massimiliano Vatiero is Senior Assistant Professor of Law and Economics at the Università della Svizzera italiana (Lugano, Switzerland). Marcello Puca is Postdoctoral Researcher at the University of Bergamo.