Theoretical analysis conducted by Gustavo Manso in 2011 suggests that the optimal incentives motivating employees to innovate must include a combination of tolerance for failures in the short term and reward for success in the long. Tolerance for early failures allows the employees to take risks at the initial stages of the innovation process without incurring the negative consequences of failed projects. The reward for the long-term success encourages the employees to explore risky ideas that may allow them to achieve innovation breakthroughs in more distant future.

In a follow-up study, Florian Ederer & Manso employed a series of laboratory experiments to provide empirical support to the above hypothesis. They showed that the best performance during an experiment was demonstrated by the participants who could explore, risk-free, different options during the first part of the experiment while being compensated for the results achieved in its second part.

Field data are supporting Manso’s theoretical conclusions, too. In a 2006 paper, Josh Lerner & Julie Wulf pointed out that beginning in the late 1980s, U.S. corporations began to increasingly link the compensation of R&D personnel to the strategic objectives of the firms. Specifically, the compensation of the heads of corporate R&D shifted towards much greater use of long-term incentives, such as stock options.

Lerner & Wulf looked at the relationship between this shift in compensation and the corporate innovation outputs. They showed that among firms with a centralized R&D organization—in which the head of corporate R&D has a greater authority over strategic decisions—a clear relationship emerges: more long-term incentives are associated with more heavily (i.e., more high-quality) patents issued to these firms. Lerner & Wulf found no relationship between patent quality and incentives offered to CFOs or heads of HR.

Similar results were obtained by Bill Francis, Iftekhar Hasan, and Zenu Sharma when the authors analyzed the relationship between innovation output and CEO compensation. In a sample of 1,106 firms operating during 1992–2005, they found that CEO compensation that enforces long-term commitment (new options grants and previously granted unvested and vested options) had a positive relationship with innovation as judged by the number of issued patents and the frequency of their citation. Further confirming Manso’s reasoning, Francis and co-authors found that so-called golden parachutes–a large payment guaranteed to the CEO in case of dismissal following a merger or takeover—also have a positive effect on corporate innovation.

It turns out that the corporate innovation benefits from granting stock options not only to CEOs and heads of corporate R&D but to the rank-and-file (non-executive) employees as well. This was the finding by Xin Chang and co-authors published in 2015. Interestingly, Chang et al. found that the effect of stock options on the employee innovation performance was stronger when the average expiration period of stock options was longer and when firms had broad-based (as opposed to targeted) non-executive option plans, which enhanced cooperation among employees.

There appear to be at least two reasons accounting for the beneficial effect of stock options on innovation. First, it’s the asymmetric payoff structure of stock options, which not only rewards employees with unlimited upside potential when innovation succeeds, and stock prices increase, but also protects them with limited downside loss when innovation fails, and stock prices fall.  Second, innovation projects are long-term, multi-stage, and labor intensive. Employee stock options with long vesting period encourage employees to stay with their firms longer while investing their intellectual capital in innovation.

A 2010 study highlighted a positive effect of non-executive stock option grants on corporate operating performance. The authors attribute this effect to increased cooperation and mutual monitoring among co-workers. The results of the above studies highlight another important function of broad-based stock option plans: fostering innovation.

The image credit: http://www.orthospinenews.com/2017/01/19/aurora-spine-corporation-grants-stock-options/

p.s. To subscribe to my monthly newsletter on crowdsourcing, go to http://eepurl.com/cE40az.