Ownership Structure and the Relationship Between Financial Slack ...

Organization Science

informs

Vol. 19, No. 3, May–June 2008, pp. 404–418 issn 1047-7039
eissn 1526-5455
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1903
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doi 10.1287/orsc.1080.0360 © 2008 INFORMS

Ownership Structure and the Relationship Between Financial Slack and R&D Investments: Evidence from Korean Firms Hicheon Kim

Korea University Business School, Seoul, 136-701, Korea, [email protected]

Heechun Kim, Peggy M. Lee

W.P. Carey School of Business, Arizona State University, Tempe, Arizona 85287 {[email protected], [email protected]}

W

e use agency theory to examine the influence of ownership structure on the relationship between financial slack and R&D investments, highlighting how that relationship might differ depending on the identity of the owners, and their potentially different interests. In doing so, we extend the scope of agency theory by examining the principal-principal conflicts of interests that may exist among different types of owners. Using a sample of Korean manufacturing firms in R&D-intensive industries between 1998 and 2003, we find that financial slack has an inverted U-shaped relationship with R&D investments. Furthermore, that relationship varies depending on the presence of different types of owners. Family ownership positively moderates the relationship between financial slack and R&D investments, whereas domestic institutional investors and foreign investors negatively moderate that relationship. Our results show that distinguishing among different types of owners is instrumental in enhancing our understanding of the nature of the relationship between financial slack and R&D investments. Key words: ownership structure; agency theory; organizational slack; R&D investments History: Published online in Articles in Advance April 7, 2008.

Corporate governance research spans multiple disciplines, including law, economics, finance, and management. In all of these literatures, the dominant paradigm has been agency theory. Nonetheless, several scholars have argued that the agency-theoretic view of corporate governance is incomplete. Specifically, this view tends to miss the principal-principal problems that exist, especially in governance systems of emerging economies (Dharwadkar et al. 2000). For example, Douma et al. (2006) find that foreign owners have different interests than domestic owners in the Indian economy, resulting in differing performance implications. It follows that who the owner is may have other firm consequences as well. In particular, principal-principal conflicts may result in differing preferences for the allocation of slack resources. The agency problem, perhaps, is most pronounced in the presence of organizational slack or excess resources, which can be applied for many different purposes without jeopardizing firm survival. Viewing organizational slack as a source of agency problems, agency theorists argue that slack breeds inefficiencies, inhibits risk taking, and hurts performance (Jensen 1986, 1989). In other words, organizational slack may discourage managers from implementing risky strategic initiatives while allowing managers to pursue their personal agenda. On the other hand, organizational

slack provides firms with a safety net and the additional resources necessary to explore new solutions and opportunities, thereby leading to greater risk taking and R&D investments (Cyert and March 1963, Greve 2003). Underlying this debate regarding organizational slack is the implicit assumption that all the firms have the same ownership structure or that different types of shareholders have the same preferences in allocating organizational slack (e.g., George 2005). However, given the principal-principal goal incongruence and the discretionary nature of organizational slack, this may not be the case. To the extent that different shareholders have different preferences in allocating organizational slack, incorporating ownership structure is crucial to deepening our understanding of the effects of organizational slack. This study examines the moderating effects of different types of owners on the relationship between financial slack and R&D investments.1 In doing so, we extend the scope and boundaries of agency theory to include the interests of differing principals. After all, different types of shareholders may have different interests in R&D investments (e.g., Kochhar and David 1996). As such, we argue that organizational slack influences R&D investments differently depending on who the investor is. For example, family owners may have different interests than outside investors. This principal-principal conflict 404

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments Organization Science 19(3), pp. 404–418, © 2008 INFORMS

of interest may result in disparate preferences for levels of R&D investments. Furthermore, this extends the work of Dharwadkar et al. (2000) who argue that firms in emerging economies are especially prone to principalprincipal goal incongruence and that principal-principal conflicts result in differences in firm performance. It follows that these principal-principal conflicts may also result in differing preferences for the allocation of slack resources. For the purpose of our study, we focus on financial or unabsorbed slack for several reasons. First, financial slack represents excess uncommitted financial resources, including cash and receivables (Bourgeois and Singh 1983, Greve 2003, George 2005). These financial resources are highly flexible and can be applied to a wide range of activities, thereby constituting highdiscretion slack (Sharfman et al. 1988, George 2005). Financial slack gives decision agents the greatest degree of freedom in allocating it to alternate uses and is more easily redeployable than other types of slack in support of R&D investments (Nohria and Gulati 1996). As such, allocation of financial slack would be amenable to the influences of different types of investors as a means of alleviating agency problems. Second, financial slack has been the focus for many previous studies (Bourgeois and Singh 1983, Greve 2003, George 2005, Nohria and Gulati 1996), providing both a theoretical and empirical consistency. Finally, financial slack more closely represents the agency-theoretic concept of free cash flow and in turn allows for a more accurate test of agencytheoretic predictions (Jensen 1986). To test our hypotheses, we use a sample of publicly traded Korean firms in R&D-intensive industries during the 1998–2003 period. South Korea offers an interesting context for several reasons. First, Korean firms are global players in various industries, including semiconductors, electronics, and automobiles. Korean firms began to compete by imitating the technological capabilities of their counterparts from developed economies. However, they have since successfully transformed themselves from imitators to creative innovators by building their own technological capabilities (Kim 1997). This transformation is made possible in no small part by Korean firms’ extensive investments in R&D (Kim 1997, Cho et al. 1998). Indeed, Korea has spent more than 2% of its GDP on R&D in the last decade, which is much higher than other emerging economies (Mitchell 1999, Varsakelis 2001). It is intriguing to examine who drives Korean firms’ R&D investments— the very investments that lay the foundation of their technological capabilities—when financial slack is available. Second and more importantly, Korean firms provide a unique context in international corporate governance research. In contrast to the Anglo-American system of corporate governance, many Korean firms are run by

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family members. In these firms, agency costs are mitigated simply because family members often assume executive positions and have incentives and the power to closely monitor and influence managerial decisions (Anderson and Reeb 2003; Demsetz and Lehn 1985; Schulze et al. 2001, 2003). Controlling shareholders such as family members, however, generate another unique set of problems among various types of owners (La Porta et al. 1999). In Korea, traditional principalagent problems between shareholders and managers may be supplanted by principal-principal problems between family members and outside shareholders. Furthermore, in Korea, outside investors, including domestic institutional investors and foreign investors, can potentially influence how financial slack is allocated. Thus, Korean firms represent an interesting hybrid of ownership structures—especially with the dramatic changes that have occurred since the 1997 Asian financial crisis. In addition, compared to developed economies, emerging economies such as Korea suffer from limited disclosure of firm information, few mechanisms to protect the minority shareholder, and irregular enforcement of corporate governance laws (La Porta et al. 2000b). Such differences in broad national governance contexts would affect incentives, investment horizons, and capabilities of different types of shareholders to monitor and influence firm management. Thus, the Korean context offers an opportunity to enhance our understanding of the roles that different inside and outside shareholders play in firms’ R&D investments in the national governance context of an emerging economy. This paper is structured as follows. In the next section, we first propose the main hypothesis about the relationship between financial slack and R&D investments, and then develop hypotheses to examine the moderating effects of ownership structure on this relationship. Next, we present the results of our analyses. Finally, we conclude with implications and directions for future research.

Theory and Hypotheses Financial Slack and R&D Investments Financial slack provides firms with the autonomy and resources necessary to explore new solutions and opportunities, thereby facilitating risk taking. Cyert and March (1963) suggest that increased organizational resources allow firms to engage in more experimentation, risk taking, and innovation. R&D investments are a case in point. R&D investments often entail search into unknown territories, and their outcomes are neither immediate nor certain. They may not result in any payoff (they may be entirely unproductive), or may translate into profits only after many years. Under these circumstances, excess resources and safety nets offered by financial slack enable firms to pursue new ideas

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and projects that require longer investment horizons, and whose outcomes are more uncertain and remote in time and space (Bourgeois 1981, March 1991). To the extent that financial slack promotes experimentation, risk taking, and long-term orientation, it can facilitate R&D investments. In a similar vein, O’Brien (2003, p. 420) argued and found evidence that financial slack is important to firms competing on the basis of innovation because it “helps to provide insulation against cash flow volatility and ensures that investments in R&D are maintained even during bad times.” Others have argued that slack enables firms to purchase and adopt innovations (Damanpour 1987, 1991). However, as financial slack increases further, a negative picture of financial slack may emerge. That is, financial slack—rather than providing the excess resources and safety nets necessary for experimentation and risk taking—nullifies the firm’s incentives to adapt to environmental shifts and to engage in risky projects that can rejuvenate its competitive advantage. For instance, Jensen (1986) argues that free cash flow, which is conceptually close to financial slack in this study, allows firms to invest in dubious projects, such as unrelated diversification. In fact, fewer resources—rather than more resources—may induce firms to be efficient and innovative in mobilizing and allocating resources (Baker and Nelson 2005, George 2005). This view claims that, equipped with too much slack, firms may become complacent and overly optimistic, and feel less compelled to make investments in R&D. In other words, too much financial slack breeds organizational complacency and inertia, thereby dampening incentives for experimentation and risk taking. Thus, it is likely that the effects of financial slack on experimentation and risk taking vary depending on the level of financial slack. Up to a certain level, financial slack encourages R&D investments; however, beyond that point, financial slack discourages R&D investments. In a similar vein, Nohria and Gulati (1996) find that the effect of organizational slack on innovation is curvilinear, or inverted U-shaped.2 Thus, we hypothesize that: Hypothesis 1 (H1). Financial slack will have an inverted U-shaped relationship with R&D investments. Role of Different Owners The corporate governance literature distinguishes between insiders and outsiders because insiders are more likely to gain access to critical information and to exert a strong influence on strategic investments than are outsiders (Baysinger and Hoskisson 1990). Because of differences in access to inside information and the ability to influence firm management, different investors might have different investment horizons and incentives to monitor the firm, thereby preferring different ways of using organizational slack (Fiss and Zajac 2004,

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

Ramaswamy et al. 2002). Alternatively, there may simply be differences in opinions among investors over whether financial slack exists and/or how financial slack should be used. Thus, we propose that how financial slack is allocated for R&D investments is contingent on the identity of the owners and their potentially different interests. Specifically, we distinguish among four types of owners: family members, affiliated firms, domestic institutional investors, and foreign investors. Using the traditional insider-outsider distinction (Baysinger and Hoskisson 1990), founders and family members are categorized as insiders, whereas domestic institutional investors and foreign investors are outsiders. Group-affiliated firms in the same business group in emerging economies are legally independent from one another and could technically be classified as outside owners. However, they are often linked through a cross-shareholding mechanism. Family members often have the control over firms in excess of their cash-flow rights (La Porta et al. 1999, Chang 2003a). For example, Chang (2003a) reported that, with only 14.1% of the group’s total equity, the Chey family controlled the fifth-largest Korean business group, SK, as of 1997. Similarly, Chairman Chung of Hyundai Motor Group enjoyed absolute power over the second-largest Korean business group with only 5.2% of the total equity of Hyundai Motor through cross shareholdings (BusinessWeek 2006b). Furthermore, because of the interlocking nature of ownership stakes among business groupaffiliated firms, these affiliated owners are able to gain access to high-quality inside information as well as to be involved in the strategic decision-making process (Chang and Hong 2000). Thus, we classify business group-affiliated firms as inside owners. Below, we develop the hypotheses about how these different types of owners moderate the relationship between financial slack and R&D investments. Inside Owners—Family Ownership. Many Korean firms are classified as family firms. Founders and their family members possess a large proportion of equity ownership, and serve as CEOs, chairpersons, or other members of the top management team. Family members, as inside owners, have access to firm-specific information and exert a strong influence over how slack is allocated among competing demands. Such informational and control advantages put family members in an advantageous position to use financial slack to pursue their interests. Some recent studies maintain that family members often abuse their information and controlling advantages to pursue private gains, often at the detriment of minority shareholders; such expropriation is more profound in emerging economies where there is often weak protection of outside investors (La Porta et al. 2000a). For instance, Bertrand et al. (2002), Bae et al. (2002), and Baek et al. (2006) reported that family members of Indian and Korean business groups tunnel profits out of

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments Organization Science 19(3), pp. 404–418, © 2008 INFORMS

member firms where they have low cash-flow rights to member firms where they have high cash-flow rights, thereby increasing their private gains and expropriating wealth from outside investors. These studies indicate that substantial conflicts of interests exist between family members and outside investors in the context of rent appropriation (Chang 2003a, Coff 1999). Insofar as family members have incentives to expropriate financial slack to their benefit, it is plausible that they are reluctant to convert greater portions of financial slack into R&D investments. However, family members play different roles with respect to rent generation. To the extent that family wealth is closely linked to firm wealth, family members have substantial economic incentives to maximize firm value (Anderson and Reeb 2003, 2004). Family members tend to be long-term investors (Anderson et al. 2003), often hoping to pass control of the firm to their descendants rather than to consume wealth during their lifetime (Casson 1999). Because family members are strongly identified with their firms, exiting from the firm by selling off their holdings may hurt their reputation as capable and trustworthy business partners. Furthermore, exiting from the firm reduces the shares that future generations will inherit, and entails significant emotional costs associated with lost legitimacy, reduced status, and contradicting family expectations (Casson 1999). Thus, family members have longer investment horizons than other shareholders, suggesting a willingness to invest in long-term projects such as R&D. Furthermore, family members are reluctant to rely on external sources to mobilize funds necessary for risky projects to the extent that they are eager to maintain and ensure control over the firm (Mishra and McConaughy 1999). Because external investors tend to lack inside information to evaluate and monitor R&D projects, external investors are more likely to demand a risk premium (Jensen and Meckling 1976, Myers and Majluf 1984). These problems are more prevalent in emerging economies where external capital markets are underdeveloped. In this situation, financial slack serves as an internal source of capital and provides more flexibility and strategic options to family members. Given that the interests of family members are aligned with the longterm performance of the firm, family members, as residual claimants, are more likely to convert greater portions of financial slack for R&D investments. Accordingly, we hypothesize: Hypothesis 2 (H2). Family ownership will positively moderate the relationship between financial slack and R&D investments such that the positive side of the inverted U-shape will become stronger and the negative side will become weaker for firms with higher levels of family ownership.

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Insider Owners—Affiliated Ownership. As mentioned earlier, because many Korean firms are part of business groups, group-affiliated firms tend to feature interlocking ownership structures, where one groupaffiliated firm owns another group-affiliated firm, and vice versa (Joh 2003). These group-affiliated firms are able to gain access to inside information and share resources within the business group (Chang 2003a, Chang and Hong 2000, Chang et al. 2006). As such, group-affiliated firms may enjoy the same information and control advantages regarding financial slack as do family members. Furthermore, group-affiliated firms, which are bound together by formal and informal ties, tend to share resources and coordinate business activities (Granovetter 1994, Khanna and Rivkin 2001). Prior studies indicate that diversified business groups serve as internal capital markets (Leff 1978, Khanna and Palepu 1997). In the internal capital market, a groupaffiliated firm can draw upon financial resources under the control of other group members as well as its own financial resources. Conversely, the group-affiliated firm’s financial resources can be tapped into by other group members as well as by the focal firm. Thus, in the internal capital market, financial decisions in the group-affiliated firm may be driven by groupwide considerations as much as by the focal firm’s considerations. Group-affiliated firms may take into consideration investment opportunities of other group member firms as well as those of the focal firm in their decisions about how to allocate financial slack. By sharing and transferring financial resources, affiliated firms of the business group can invest more than what they can afford, thereby overcoming liquidity constraints (Hoshi et al. 1991). Indeed, Shin and Park (1999) reported that the investment of the Korean group-affiliated firm is sensitive to the cash flows of other group members, rather than to its own cash flow. In transferring financial resources among business group-affiliated firms, those with excess cash flows are likely to be providers and those facing liquidity constraints are likely to be recipients (Scharfstein and Stein 2000, Lincoln et al. 1996). Under such internal financing operations, the effect of ownership by affiliated firms varies depending on the level of financial slack available to the focal firm. For firms with high levels of financial slack, affiliated ownership encourages the focal firm to save higher portions of financial slack for other members. Accordingly, the focal firm is less capable of converting financial slack into R&D investments. In contrast, for firms with low levels of financial slack, affiliated ownership may serve as a conduit to transfer additional capital necessary for long-term investments from other members. Thus, the focal firm is more capable of converting financial slack into R&D investments because affiliated ownership is less likely to encourage the focal firm to save higher portions of

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financial slack for other members. Taken together, we hypothesize: Hypothesis 3 (H3). Affiliated ownership will negatively moderate the relationship between financial slack and R&D investments such that the positive side of the inverted U-shape will become weaker and the negative side will become stronger for firms with higher levels of affiliated ownership. Outside Owners—Domestic Institutional and Foreign Ownership. Unlike family members and affiliated firms, outside owners, in general, suffer from informational and control disadvantages (Williamson 1975). Nonetheless, institutional investors may be “sophisticated” and “active” investors compared to individual investors. Indeed, domestic institutional investors have strong incentives to incur the cost of monitoring firms because they often hold substantial ownership blocks in firms. Similarly, foreign investors in emerging economies tend to be predominantly institutional investors from U.S. and European financial institutions (Choe et al. 1999). With the changes in regulations after the financial crisis, these investors are able to voice their concerns and influence managerial decisions more effectively. Before the Asian financial crisis in 1997, foreign investors in Korea were not allowed to own more than 7% of shares in a domestic Korean firm, limiting their penetration into the Korean capital markets. However, such barriers have been lifted since the financial crisis. As a consequence, foreign ownership in Korean firms increased from about 13% of publicly listed firms in 1997 to 42% in 2006 in terms of market capitalization (BusinessWeek 2006a). With the increased equity holdings in Korea, these foreign owners now exercise a larger influence on the corporate governance system than ever before (Joh 2003, Gillan and Starks 2003). Thus, foreign investors may have the same incentives to monitor and influence as domestic institutional investors. Furthermore, foreign investors often bring in the notion of “shareholder capitalism” into countries in which they invest (Useem 1998, Ahmadjian and Robbins 2005). Unfettered by prior business and social relationships with firms in which they invest, foreign investors are “pressure-resistant” (Brickley et al. 1988, Yoshikawa et al. 2005). In developed economies such as the United States, insofar as institutional investors are “active” as well as “sophisticated” investors, they are less likely to evaluate corporate executives on the basis of short-term earnings alone and are more likely to support value-creating, long-term projects (Kochhar and David 1996). Several empirical studies have corroborated this view. In the study of four research-intensive industries in the United States, Hansen and Hill (1991) found that high levels of institutional ownership are associated with greater R&D

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

expenditures. Baysinger et al. (1991) reported the same finding on a sample of 176 Fortune 500 firms. In a similar vein, David et al. (2006) reported the positive effect of foreign ownership on long-term investments such as R&D and capital investments in Japanese firms with high growth opportunities. However, in emerging economies, domestic institutional investors and foreign investors tend to be shortterm oriented because of the poor protection that they receive (La Porta et al. 2000a). Facing the expropriation hazard by controlling shareholders, these outside investors may prefer to obtain immediate gains through dividends from financial slack (Easterbrook 1984, Jensen 1989, La Porta et al. 2000b, Shefrin and Statman 1984). To the extent that outside investors prefer short-term gains such as dividends over long-term gains through R&D investments, financial slack is less likely to lead to R&D investments as their ownership increases. Thus, we hypothesize: Hypothesis 4 (H4). Domestic institutional ownership will negatively moderate the relationship between financial slack and R&D investments such that the positive side of the inverted U-shape will become weaker and the negative side will become stronger for firms with higher levels of domestic institutional ownership. Hypothesis 5 (H5). Foreign ownership will negatively moderate the relationship between financial slack and R&D investments such that the positive side of the inverted U-shape will become weaker and the negative side will become stronger for firms with higher levels of foreign ownership.

Methods Sample The sample consists of Korean manufacturing firms in R&D-intensive industries that were listed on the Korea Stock Exchange (KSE) between 1998 and 2003. Using two-digit Korean Standard Industrial Classification (KSIC) codes, we identify multiple industries including chemicals (KSIC Codes 24 and 25), machinery (KSIC Codes 29, 34, and 35), and electronics (KSIC Codes 30, 31, 32, and 33). In these R&D-intensive industries, R&D investments constitute a crucial decision that may be affected by financial slack and ownership structure. The data come from the Korea Investors Services (KIS) database, which reports firm profile, financial information, and ownership information. This database has been used in previous studies that employed a sample of Korean firms (e.g., Chang 2003a). We first identify a total of 262 firms, but 9 firms report incomplete information on firm profile, financial information, and ownership information. Therefore, we drop them and have a usable sample of 253 firms and 1,314 firmyear observations during the 1998–2003 period (unbalanced panel data). We take a one-year time lag between

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments Organization Science 19(3), pp. 404–418, © 2008 INFORMS

independent and control variables, and our dependent variable. As such, the independent and control variables cover the 1998–2003 period, whereas the dependent variable covers the 1999–2004 period. Variables Dependent Variable. We use R&D intensity, measured as the ratio of R&D expenditures to total sales. This measure has been widely used in previous studies (e.g., Greve 2003, Lee and O’Neill 2003). Independent Variables. As noted earlier, we focus on financial slack. Financial slack is measured as the ratio of quick assets (cash and marketable securities) to liabilities (e.g., Singh 1986, Greve 2003). Following previous studies (Chang 2003a, Baek et al. 2004), we measure ownership structure as follows: (1) Family ownership is the sum of equity ownership by family members, including founders and descendants; (2) affiliated ownership is the sum of equity ownership by firms and financial institutions that belong to the same business group; (3) domestic institutional ownership is the total percentage of equity ownership held by domestic institutional investors composed of insurance companies, securities firms, and merchant banks, which do not belong to the same group as the firm being examined. We exclude domestic financial institutions belonging to the same group from this category. (4) Foreign ownership is measured as the percentage of equity ownership held by both foreign firms and foreign financial institutions following Khanna and Palepu (2000). Control Variables. Previous studies have shown that several variables can influence the level of R&D investments; these include previous investments in R&D (Hansen and Hill 1991), stock concentration (Lee 2005), firm performance, business group affiliation (Mahmood and Mitchell 2004), and product diversification (Hansen and Hill 1991). Thus, our control variables also include lagged R&D (R&D intensity from the previous year), stock concentration (measured as the total percentage of stock held by large shareholders with at least 5% of a firm’s stock), and firm performance, measured as return on assets (ROA). To control for the effect of business group affiliation on R&D investments (Mahmood and Mitchell 2004), we use a dummy variable. Although business groups are defined as organizations with more than two group-affiliated firms, not all business groups exert the same influence. In particular, the top 30 business groups in Korea not only represent Korea’s most prominent business groups, but also are subject to stricter regulations (Bae et al. 2002). Accordingly, if a firm belongs to one of the top 30 business groups, it is coded 1, and otherwise 0. We identify the top 30 business groups using a ranking provided by the Korea Fair Trade Commission, which provides annual rankings based on the size of the

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total assets of all group-affiliated firms (Shin and Park 1999). To control for the effect of product diversification on R&D investments (Hansen and Hill 1991), we use the imputed weighted diversification index measure of product diversification based on the market segment data from Worldscope and KIS (Gedajlovic and Shapiro 1998, Wan and Hoskisson 2003). This is calculated as
follows: Degree of product diversification = Pi × dij , where i = a firm’s primary market segment; j = a firm’s secondary market segment; dij = 0 if the firm operates in only one four-digit industry, dij = 1 if the j is in the same three-digit industry as i, dij = 2 if the j is in the same two-digit industry as i, and dij = 3 if i and j are in different two-digit industries; and Pi = a weight imputed to each industry, assumed to decline geometrically: 1, 2, 4, 8, and 16. We also control for firm size and firm age. Firm size is measured by the natural logarithm of total sales (Baysinger et al. 1991). Firm age, measured as the difference between the year when a firm is observed in our sample and the year when the firm was founded, is also controlled for. Because demand conditions and stage of product life cycle of a firm’s products may affect R&D investments, we control for sales growth, measured as the percent change in annual total sales. We control for the effect of firm risk, measured as the standard deviation of monthly stock returns for the prior 60 months (Anderson and Reeb 2003). Although we are interested in the relationship between financial slack and R&D investments, we also control for the effects of absorbed slack and potential slack on R&D investments (e.g., Bourgeois and Singh 1983, Singh 1986, George 2005, Greve 2003). Absorbed slack is measured as the ratio of selling, general, and administrative expenses to total sales and considered for the possible curvilinear effect on R&D investments. Potential slack is measured as the ratio of total liabilities to total equity and considered for the possible curvilinear effect on R&D investments. We control for industry effects on R&D investments in two ways. First, we control for industry average R&D investments based on two-digit KSIC codes. Second, we control for other industry effects by using eight industry dummy variables based on two-digit KSIC codes. Finally, we include five calendar-year dummies to control for year effects. Model Specification Because we have cross-sectional time-series data, the ordinary least squares (OLS) method is not appropriate because it does not correct for within-firm autocorrelation and cross-sectional heteroscedasticity. To control for these issues, we employ the generalized least squares (GLS) method. Furthermore, a Hausman test reveals that the estimated panel error is not correlated with independent variables, an assumption necessary for use of a random-effects model. Thus, we test our hypotheses by

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using a random-effects generalized least squares (GLS) regression (Wooldridge 2002).

Results

The means, standard deviations, and correlations are reported in Table 1. We examine the variance inflation factors (VIFs) to detect multicollinearity. All of the VIF scores are below 3 and the mean VIF score is 1.55. Because a commonly used rule of thumb for multicollinearity is 10 or fewer, our analyses are unlikely to have a serious problem with multicollinearity (Cohen et al. 2003). We also center the interaction variables to avoid multicollinearity. The results of the analyses are shown in Table 2. H1 predicts that financial slack has an inverted U-shaped relationship with R&D investments. The result of Model 2 shows a positive coefficient on the financial slack term and a negative coefficient on its squared term. Both of these coefficients are statistically significant (p < 005). Thus, our results support H1 and are consistent with the findings of Nohria and Gulati (1996). In H2, we predict that family ownership positively moderates an inverted U-shaped relationship between financial slack and R&D investments. Model 3 suggests that H2 is marginally supported (p < 010). To illustrate the complex interaction effect, we rely on a surface plot using three standard deviations from the means of financial slack and family ownership, as illustrated in Figure 1. In the front of the figure, financial slack has an inverted U-shaped relationship with R&D investments. As family ownership increases, the positive relationship between financial slack and R&D investments becomes stronger, and the negative relationship between financial slack and R&D investments becomes weaker, eventually turning positive. Figure 1 provides additional supporting evidence of H2. H3 posits that affiliated ownership negatively moderates an inverted U-shaped relationship between financial slack and R&D investments. As reported in Model 4, we find that H3 is not supported. Although the coefficient on the interaction term is negative and consistent with H3, it fails to reach statistical significance. By grouping family ownership and affiliated ownership together into inside ownership, we conduct an additional analysis that examines the moderating effect of inside ownership on an inverted U-shaped relationship between financial slack and R&D investments. We find that inside ownership does not moderate an inverted U-shaped relationship between financial slack and R&D investments. It seems that the opposite moderating effects of family ownership and affiliated ownership wash out, thereby leading to the insignificant moderating effect of inside ownership. This suggests that grouping family ownership and affiliated ownership together may give rise to misleading findings; that is, not all inside owners are identical—who the owner is matters.

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Lastly, we test H4 and H5, which predict that domestic institutional ownership and foreign ownership negatively moderate an inverted U-shaped relationship between financial slack and R&D investments. Consistent with our predictions, Models 5 and 6 show that domestic institutional ownership and foreign ownership negatively moderate the relationship between financial slack and R&D investments (p < 005; p < 005). This provides support for both H4 and H5. As in H2, we rely on a surface plot using three standard deviations from the means of financial slack, domestic institutional ownership, and foreign ownership to better understand the moderating effects. Both Figures 2 and 3 show that as domestic institutional ownership or foreign ownership increases, the positive relationship between financial slack and R&D investments becomes weaker (i.e., less positive), and the negative relationship between financial slack and R&D investments becomes stronger (i.e., more negative). Figures 2 and 3 provide additional supporting evidence of H4 and H5. Furthermore, we provide additional analysis by grouping domestic institutional and foreign ownership into outside ownership to show the moderating effect of outside ownership on an inverted U-shaped relationship between financial slack and R&D investments. We find that outside ownership negatively moderates an inverted U-shaped relationship between financial slack and R&D investments (p < 005). The findings suggest that unlike inside owners, outside investors raise the same voice toward R&D investments. Among control variables, both absorbed and potential slack are found to have an inverted U-shaped relationship with R&D investments. Whereas Greve (2003) found a statistically significant positive relationship between absorbed slack and R&D investments and no relationship between potential slack and R&D investments, our findings suggest that, as with financial slack, too much absorbed or potential slack is also detrimental to R&D investments. As Thompson (1967) pointed out, too much slack tends to insulate the firm from exogenous shocks, thereby creating complacency. Our findings confirm that this is true for all types of organizational slack. Stock concentration and business group affiliation are found to have no bearing on R&D investments. These findings may indirectly attest to the significance of identity of owners in understanding levels of R&D investments. The notion of stock concentration neglects the identity of shareholders, as does the notion of business group affiliation. However, our findings indicate that the identities of shareholders matter above and beyond stock concentration and business group affiliation. In addition, our findings show that family ownership, affiliated ownership, and domestic institutional ownership have no main effects on R&D investments, whereas foreign ownership is positively related to R&D investments. In

R&D investments Financial slack Family ownership Affiliated ownership Domestic institutional ownership Foreign ownership Prior R&D investments Stock concentration Firm performance Business group Product diversification Firm size∗ Firm age Sales growth Firm risk Absorbed slack Potential slack Industry average R&D

6
87 1
95 35
76 2
58 0
15 0
79 18
76 33
31 10
96 0
20 0
16 3
36 1
92

1
92 0
36 20
50 11
31 8
27

Mean

12
37 3
42 18
17 13
60 0
36 0
49 1
47 14
18 87
84 0
06 0
19 26
55 1
21

2
61 0
59 16
67 15
81 11
14

S.d.

0
12 0
85 −0
07 0
02 0
08 0
03 0
09 −0
08 −0
00 0
00 0
14 −0
01 0
34

0
26 0
01 −0
07 0
03

1

0
14 0
36 0
05 0
15 −0
17 −0
02 −0
14 −0
11 −0
02 −0
13 −0
01 −0
06 0
30

0
17 −0
09 −0
01

2

−0
15 0
02 0
19 0
11 −0
34 −0
01 −0
28 −0
02 −0
02 −0
15 −0
04 −0
07 −0
05

−0
46 −0
24

3

0
20 −0
06 0
41 0
03 0
27 −0
05 0
24 −0
05 0
02 −0
11 −0
08 0
05 −0
06

−0
03

4

0
12 0
03 0
13 0
10 0
21 0
07 0
35 0
07 −0
02 −0
06 −0
06 −0
02 0
00

5

0
07 0
13 0
14 0
22 0
06 0
42 −0
06 0
01 −0
21 −0
08 −0
05 0
01

6

−0
06 −0
03 0
08 0
02 0
04 −0
11 −0
03 0
02 0
14 −0
02 0
41

7

0
19 −0
03 −0
05 0
06 −0
21 −0
01 −0
13 −0
08 0
00 −0
09

8

−0
01 0
00 0
11 −0
03 0
05 −0
10 −0
13 −0
20 −0
15

9

0
19 0
66 −0
05 −0
01 −0
05 −0
10 −0
01 0
02

10

0
22 0
07 0
03 −0
02 −0
04 −0
04 −0
07

11

0
10 −0
01 −0
23 −0
25 −0
01 −0
01

12

−0
04 −0
03 0
18 0
02 −0
12

13

0
11 −0
02 −0
00 −0
04

14

0
13 0
03 0
05

15

−0
01 0
06

16

−0
01

17

Notes. N = 1314. Correlations greater than or equal to 0.07 are significant at p < 0
01 (two-tailed). Correlations greater than or equal to 0.06 are significant at p < 0
05 (two-tailed). ∗ Logarithm.

6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

1. 2. 3. 4. 5.

Variable

Table 1 Descriptive Statistics and Correlations

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

411

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments

412

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

Table 2

Results of GLS of R&D Investments on Organizational Slack and Ownership Structure

Variable Intercept Prior R&D investments Stock concentration Firm performance Business group

Model 1

Model 2

Model 3

Model 4

Model 5

Model 6

∗

∗

∗

∗

∗

−1
881∗ 0
895

−2
194 0
888 0
630∗∗∗ 0
013 −0
001 0
003 0
008∗∗ 0
003

−2
005 0
895 0
691∗∗∗ 0
016 −0
001 0
003 0
008∗∗ 0
003

−1
882 0
882 0
690∗∗∗ 0
016 −0
002 0
003 0
008∗∗ 0
003

−1
992 0
889 0
691∗∗∗ 0
016 −0
001 0
003 0
008∗∗ 0
003

−2
000 0
895 0
688∗∗∗ 0
016 −0
002 0
003 0
008∗∗ 0
003

0
687∗∗∗ 0
016 −0
001 0
003 0
008∗∗ 0
003

−0
072 0
148

−0
079 0
146

−0
098 0
146

−0
090 0
147

−0
090 0
145

−0
086 0
146

Product diversification

0
015 0
081

0
018 0
079

0
018 0
079

0
019 0
080

0
017 0
080

0
016 0
079

Firm size

0
127∗∗ 0
043

0
109∗ 0
043

0
107∗ 0
043

0
109∗ 0
043

0
113∗∗ 0
043

0
108∗ 0
043

Firm age

0
000 0
003

0
001 0
003

0
001 0
003

0
001 0
003

0
002 0
003

0
001 0
003

Sales growth

0
000 0
000

0
000 0
000

0
000 0
000

0
000 0
000

0
000 0
000

0
000 0
000

Firm risk

0
112 0
736

0
278 0
740

0
235 0
740

0
277 0
740

0
138 0
741

0
296 0
739

Absorbed slack

1
497∗∗∗ 0
409

0
960∗ 0
412

0
932∗ 0
412

0
953∗ 0
412

0
958∗ 0
411

0
957∗ 0
411

−0
174† 0
096

−0
163† 0
097

−0
173† 0
097

−0
171† 0
096

−0
176† 0
096

0
009∗ 0
004

0
009∗∗ 0
003

0
009∗ 0
003

0
009∗∗ 0
003

0
009∗∗ 0
003

0
009∗∗ 0
003

Potential slack squared

−0
000† 0
000

−0
000† 0
000

−0
000† 0
000

−0
000† 0
000

−0
000† 0
000

−0
000† 0
000

Industry average R&D

−0
367∗∗∗ 0
058

−0
275∗∗∗ 0
059

−0
285∗∗∗ 0
060

−0
275∗∗∗ 0
059

−0
285∗∗∗ 0
059

−0
282∗∗∗ 0
059

0
002 0
004

0
001 0
003

0
002 0
003

0
001 0
003

0
001 0
003

0
001 0
003

Affiliated ownership

−0
004 0
004

−0
004 0
004

−0
003 0
004

−0
004 0
004

−0
003 0
004

−0
004 0
004

Domestic institutional ownership

−0
003 0
004

−0
003 0
004

−0
003 0
004

−0
003 0
004

−0
006 0
004

−0
003 0
004

0
006† 0
003

0
006 0
004

0
006† 0
004

0
006 0
004

0
006 0
003

0
006† 0
004

0
203∗ 0
109

0
097 0
107

0
129 0
106

0
185∗ 0
103

0
203∗ 0
108

−0
085∗∗∗ 0
015

−0
087∗∗∗ 0
015

−0
086∗∗∗ 0
016

−0
092∗∗∗ 0
016

−0
090∗∗∗ 0
016

Absorbed slack squared Potential slack

Family ownership

Foreign ownership

−0
273∗∗ 0
096

Financial slack Financial slack squared

0
007† 0
006

Financial slack × Family ownership Financial slack × Affiliated ownership

−0
003 0
007 −0
019∗ 0
008

Financial slack × Domestic institutional ownership

−0
008∗ 0
005

Financial slack × Foreign ownership Wald 2

3507
22∗∗∗

3670
10∗∗∗

3673
62∗∗∗

3667
69∗∗∗

3688
22∗∗∗

3677
41∗∗∗

Notes. Dummy variables for year and industry were included in models but are not reported in the table. Unstandardized regression coefficients are shown. Standard errors are in parentheses. † p < 0
10, ∗ p < 0
05, ∗∗ p < 0
01, ∗∗∗ p < 0
001 (one-tailed tests for hypothesized effects).

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments

413

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

Figure 1

Testing Hypothesis 2 (Moderating Effect of Family Ownership)

Figure 3

Testing Hypothesis 5 (Moderating Effect of Foreign Ownership)

2.2 2.1

R&D investments

R&D investments

2.8 2.6 2.4 2.2 2.0

1.9 1.8 1.7 1.6 1.5

1.8

40

60 2.0

40

Fam

1.5

ily o

wne

1.0

20

rshi p

0

0

0.5

ack cial sl

Finan

particular, intriguing findings are that although foreign ownership is positively related to R&D investments, it negatively moderates the relationship between financial slack and R&D investments. As shown in Figure 3, foreign ownership is positively related to R&D investments when financial slack is small. However, foreign ownership becomes negatively related to R&D investments as financial slack increases. The findings suggest that the relationship between foreign ownership and R&D investments depends on levels of financial slack. Conversely, these findings indicate that our understanding of the relationship between financial slack and R&D investments is enhanced by incorporating ownership structure.

Discussion and Conclusions

Drawing primarily on agency theory, we examine and show how, in the presence of financial slack, different Figure 2

Testing Hypothesis 4 (Moderating Effect of Domestic Institutional Ownership)

2.0

R&D investments

2.0

1.5 1.0 0.5 0

– 0.5 40

Do

me

stic

2.0

30

ins

1.5

titu

20

tio

nal

1.0

10

ow

ner

0.5 0

shi

p

0

ck l sla

F

cia inan

30

For

2.0

eig

20

no

1.5 1.0

wn

ersh 10 ip

0

0

0.5

ack

l cial s Finan

types of owners affect R&D investments in emerging economy firms. To do so, we first explored the nature of the relationship between financial slack and R&D investments. Consistent with Nohria and Gulati (1996), we found an inverted U-shaped relationship between financial slack and R&D investments in emerging economy firms. That is, both too much and too little financial slack may inhibit R&D investments. However, the main-effect finding cannot explain why and how some firms are more likely than others to encourage or discourage R&D investments, especially when financial slack is available. We developed and found general support for the proposition that different types of owners affect how financial slack is allocated. Specifically, we found that family ownership positively moderates the relationships between financial slack and R&D investments. In other words, family ownership leads to investing a greater portion of financial slack in R&D. Our findings suggest that family members are indeed long-term investors and generate rent through R&D investments. In a sense, our findings can be viewed as contradictory to those of some recent studies that focus on expropriation of outside investors by family members in emerging economies (e.g., Johnson et al. 2000). They emphasize substantial agency problems between family members and outside investors in the context of rent appropriation (Chang 2003a, Coff 1999). Family members, however, appear to play different roles with respect to rent generation. Although family members can expropriate value at the expense of outside investors, they are also instrumental in generating rent by converting a greater portion of financial slack into long-term investments. Korean firms are increasingly becoming global players in various industries through their aggressive R&D investments (Kim 1997, Cho and Lee 2003, Cho

414

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments

et al. 1998). Our findings suggest that it is family members who drive Korean firms to invest in R&D investments. Although their reasons may be to pass a larger, healthier firm onto their descendants, the resulting tendency is to invest more in R&D. However, once the rent is generated, there may be serious conflicts of interests over how it is distributed among different types of shareholders (Coff 1999). Thus, family ownership, in and of itself, may not be problematic insofar as the broad corporate governance context allows outside investors to monitor and discipline family members (Anderson and Reeb 2003). Increasing transparency and legal protection of outside investors also contribute to enhancing value-creating potentials of family ownership in the rent generation process and nullifying its value-expropriation potential. Comparative studies across countries with different national governance systems would reveal how the effects of family ownership are contingent upon differences in national governance systems. Contrary to our hypothesis, results show that affiliated ownership has no moderating effect on allocation of financial slack. We hypothesized that, as affiliated ownership in a firm increases, the firm is more able to draw on financial resources from some members and transfer financial resources to other members. However, it is plausible that the firm may become part of the business group’s internal capital market operation insofar as it is under control of family members regardless of affiliated ownership levels. In fact, business groups in Korea—with controlling families—are more akin to the U.S. conglomerate firm. They typically have powerful group headquarters assisted by a large staff and elaborate control systems (Chang 2003b). Collaboration and coordination are thus achieved on the basis of “hierarchical fiat,” rather than “mutual recognition” (Nakatani 1990). In other words, it may be controlling families, not levels of affiliated ownership, who dictate the flow of financial resources among affiliated firms. We also show that both domestic institutional ownership and foreign ownership negatively moderate the relationship between financial slack and R&D investments. These findings are different from the prior studies primarily based on the U.S. data. In general, research based on U.S. firms suggests that institutional investors are long-term investors (Allen 1993, David et al. 2001). However, our findings suggest that the effects of domestic institutional ownership and foreign ownership may vary depending on the broad national governance system (Dharwadkar et al. 2000). In the presence of strong disclosure requirements and legal protection of outside investors as in developed economies, institutional investors can serve as “sophisticated” and “active” investors, promoting long-term investments. However, in emerging economies, the governance system often offers weak protection of outside investors. With weak protection, these outside investors, such as domestic

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

institutional investors and foreign investors, may become short-term oriented. Facing the expropriation hazard by controlling shareholders, outside investors may avoid making long-term investments and prefer short-term rather than long-term gains. Our findings also show that the effect of ownership structure on R&D investments increases as levels of financial slack increase. For instance, in the absence of financial slack, neither family ownership nor domestic institutional ownership has an impact on R&D investments. However, when there is financial slack of 1.54% (mean plus two standard deviations), a 10% increase in family ownership leads to a 0.10% increase in R&D intensity; similarly, a 10% increase in domestic financial ownership leads to a 0.28% decrease in R&D intensity. With average R&D intensity of 1.92% in our sample (see Table 1), these figures represent 5% and 15% changes in R&D intensity. These findings indicate that principalprincipal goal incongruence is aggravated in the increasing presence of financial slack. Policy and Managerial Implications This study emphasizes the importance of strong legal protection of outside investors to encourage them to become long-term investors (La Porta et al. 2000a). Many emerging economies, including Korea, are still known as countries with weak legal protection for outside investors despite recent amendments to its legal system (Solomon et al. 2002). Under weak legal protection, outside investors may not be able to afford longer time horizons in their investment decisions. Thus, in the absence of strong legal protection, the increasing presence of domestic institutional investors may generate unintended consequences. Facing pressures for shortterm profitability by domestic institutional investors, firms may forgo long-term investments, and may lose global competitiveness over time. Similarly, without strengthening legal protection of outside investors, opening up domestic capital markets to foreign investors may have similar consequences. Thus, in understanding the effects of outside investors, the nature and extent of legal protection in place may be at least as important as the identity of outside investors. It is important for policy makers to recognize that, depending on the broad national governance system, outside investors could have a different impact on resource allocation and risk-taking propensities, which ultimately have crucial implications for national competitiveness. Firm-level governance attributes within a single country may also influence investment horizons of outside investors. Disclosing high-quality firm-specific and accounting information would reduce information asymmetries between family members and outside investors, possibly resulting in more long-term oriented outside investors (Baek et al. 2004, Fan and Wong 2002, Mitton

Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments Organization Science 19(3), pp. 404–418, © 2008 INFORMS

2002). Adopting governance practices that provide better protection of outside investors may also have the same effects (Black et al. 2006). Thus, firms can enhance investment horizons of outside investors by embracing high-quality disclosure and governance practices. Contributions and Limitations We contribute to the literature on financial slack by providing evidence about how financial slack relates to R&D investments. Agency theorists emphasize the discretionary nature of financial slack, arguing that it is subject to managerial opportunism (Jensen 1986), whereas others argue that financial slack serve as a buffer from environmental contingencies, which allows the firm to engage in experimentation, risk taking, and R&D investments (e.g., Cyert and March 1963). Our findings suggest that financial slack has an inverted U-shaped relationship with R&D investments. Consistent with Nohria and Gulati (1996), this study serves to reconcile the theoretical debate over the relationship between financial slack and R&D investments, especially in an emerging economy context. More importantly, our findings show that the identity of the owner matters; different types of owners have different preferences over how financial slack is allocated in competing demands. Whereas family members prefer to make long-term investments and wait for longterm gains, domestic financial institutions and foreign investors seem to prefer short-term gains. Some of the agency problems that managers are believed to engender might actually be a reflection of conflicts of interests among different types of shareholders. In the presence of principal-principal conflicts, actions that managers take are likely to please some shareholders more than others. Thus, under such circumstances, traditional agency conflicts between shareholders and managers may be overstated, or managers are wrongly accused of being opportunistic. More research investigating the effects of different types of shareholders might shed more insights into complex agency problems around firms. Underlying agency theory is the implicit assumption that different types of shareholders and managers know how financial slack should be allocated, despite conflicts of interests among themselves (Allen 1993). However, this assumption may not be valid in situations entailing high complexity and uncertainty, such as R&D-intensive industries. There may simply be differences in opinions among investors over how financial slack should be used (Davis and Stout 1992). They may even disagree over how much slack there is. For instance, two U.S. financiers, Carl Icahn and Warren Lichtenstein, pressed KT&G (formerly the state-owned Korean Tobacco & Ginseng) to spin off and list the firm’s fast-growing ginseng unit, sell holdings of property, sell stakes in a convenience-store chain, and boost dividend and buy back shares (Economist 2006). They believed that KT&G

415

possessed high levels of organization slack, which should be returned to shareholders; KT&G executives, however, had different views. Because the firm’s monopoly in the ginseng market ended in 2002, executives believed that more work was necessary to make the ginseng unit competitive enough to face new entrants. Likewise, they viewed their stake in the convenience-store chain as a source of important complementary assets, not as unnecessary slack. The conflicts between foreign investors and management may be a reflection of both different perceptions and different interests. Where such perceptual differences come from and how they interact with differences in interests would both complement and extend the corporate governance literature. Our study is based on an emerging economy, Korea. As such, our findings may be limited in generalizability. Our findings indicate that national governance contexts may be germane to understanding the implications of firm-specific governance issues. For instance, whereas institutional investors in the United States appear to be long-term oriented (Hansen and Hill 1991), we found that domestic institutional investors as well as foreign investors are more short-term oriented in Korea. One explanation for this is that legal protection of outside investors is weak, resulting in a focus on short-term gains. Comparative studies that incorporate both variations in national governance attributes and firm-level governance attributes would be a fruitful arena for future research. Our findings are also limited to firms in R&D-intensive industries, and, as such, may not be generalizable to other settings. For instance, our findings indicate that family members are more willing to support for long-term projects such as R&D investments—in R&D-intensive industries where R&D is essential to the firm’s competitive advantages. However, in mature and/or declining industries, it may be plausible that family ownership may have no or negative association with R&D investments and risk taking. It awaits further conceptualization and analysis of how family and other types of ownership influence the firm’s resource allocation and strategy differently depending on industry attributes. Our study examines principal-principal conflicts in the context of R&D investments. Principal-principal conflicts also exist with respect to other corporate strategies. For example, product and international diversification are growth strategies, whereas corporate refocusing is a contraction strategy. It is intriguing to examine how different types of owners are more or less likely to support differing types of corporate strategies. In addition, different types of ownership may complement each other. For example, inside owners such as family members can bring firm-specific expertise and long-term orientation to corporate governance, but they also have controlling power to expropriate minority shareholders. In contrast, outside owners, such as domestic institutional

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Kim et al.: Ownership Structure and the Relationship Between Financial Slack and R&D Investments

investors and foreign investors, can bring stronger discipline and objectivity. Thus, the presence of inside and outside owners offers complementary skills in the context of corporate governance, and, as such, the effects of family ownership would be contingent upon the existence and levels of outside ownership. Good corporate governance may require a prudent balance of different types of ownership. Future research should explore principal-principal conflicts in the context of different corporate strategies in order to fill these gaps that we leave unanswered. In sum, the governance literature presumes that “governance problems are largely a result of the agency problems that arise from the separation of ownership and control in the large-scale, public corporation” (Bradley et al. 1999, p. 11). Our study shows that this assumption may be problematic, especially in an emerging economy. In the presence of controlling shareholders, the principal-principal conflicts, rather than the principalagent conflicts, become an important source of agency problems. Often, different shareholders have different incentives, investment horizons, and abilities to monitor and control firm management. Indeed, our findings indicate that different shareholders have disparate preferences for R&D investments, thereby differently moderating the relationship between financial slack and R&D investments. Examining the identity of shareholders and the potential principal-principal conflict is necessary in enriching our understanding of how ownership structure in particular, and corporate governance in general, affect the firm’s resource allocation, strategy, and performance. Acknowledgments

The authors appreciate the valuable comments from Ed Zajac, the three anonymous reviewers, and the seminar participants at Arizona State University, Korea University Business School, and Northwestern University. The first author acknowledges the financial support of the Korea University Grant and of the IBRE Research Fund at Korea University Business School.

Endnotes 1

One implicit assumption in our study is that R&D investments are beneficial in the creation of firm-specific advantages and shareholder wealth. In the strategy literature, R&D investments have been used as a proxy of intangible assets, which constitute sources of competitive advantages (e.g., Chang and Hong 2000, Song et al. 2005). In the finance literature, several studies document a relationship between R&D investments and stock price. For example, McConnell and Muscarella (1985) and Chan et al. (1990) find that stock prices respond positively to announcements of capital and R&D expenditures. A more recent study by Eberhart et al. (2004) finds that R&D increases are beneficial investments, leading to positive long-term abnormal operating performance. Thus, R&D investments appear to be beneficial to creating competitive advantages and shareholder value in both the short and long term. 2 Note that, using survey data, Nohria and Gulati measured innovation broadly to include “any policy, structure, method

Organization Science 19(3), pp. 404–418, © 2008 INFORMS

or process, product or market opportunity that the manager of the innovating unit perceived to be new” (1996, p. 1251).

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