Freedom to fail, freedom to innovate

(This post originally appeared on InnovationManagement.se)

Everyone seems to agree that innovation is a risky business: it involves a lot of experimentation, which often ends up in failure. High tolerance for failure, therefore, can be considered as a major prerequisite for any successful innovation program.

While talks about accepting or even “celebrating” failures are becoming commonplace, little attention is being paid to how positive attitude towards failure should be promoted. Which specific policies could be put in place to make safe–and, better yet, attractive–for firms and their employees to engage in innovation activities?

The “labor law” of innovation

Academic research provides useful guidance with respect to what these policies should be. Theoretical analysis by Gustavo Manso suggests that conditions incentivizing employees to innovate must include tolerance for early failures, which would allow them to take risks at the initial stages of the innovation process without facing negative consequences of failed projects.

Available empirical evidence supports Manso’s conclusion. For example, an analysis of the impact of labor laws on innovation in five countries showed that stronger labor laws positively correlated with a country’s innovation output. In another study, the impact on innovation of the U.S. wrongful discharge laws (WDL) was investigated. These laws provide employees with greater protection than employment-at-will, under which they can be terminated with or without just cause. The WDL, particularly those that protect employees from termination in bad faith, were found to foster innovation by increasing the employees’ motivation and effort.

These results strongly suggest that innovation is promoted by laws that limit firms’ ability to discharge employees at will. Experts call this phenomenon an “insurance effect”: feeling increased protection from negative consequences of failure, employees are more committed to engaging in risky innovative projects.

Innovation and bankruptcy laws

It turns out that corporate innovation is encouraged not only by protecting individual employees but the firms, too. A study of bankruptcy laws in 12 countries showed that more debtor-friendly bankruptcy codes (i.e., codes favoring firms filing for bankruptcy) had a positive effect on corporate innovation. The debtor-friendly laws encourage firm-level innovation by promoting the continuation of innovative activities even following the firm’s bankruptcy.

Innovation and investment

Another piece of evidence that tolerance for failure positively affects corporate innovation comes from a study investigating how venture capital (VC) investors deal with failures of startup firms they fund. Startups have high innovation potential, but they also carry a substantial risk of failure; innovation failure tolerance is therefore very important to them. That’s why VC investors’ own tolerance for failure is crucial. If they can’t tolerate early failures, they would prematurely liquidate a startup upon initial unsatisfactory progress and thus prevent it from realizing the startup’s true innovation potential.

The study shows that startups backed by more tolerant VC investors are significantly more innovative. The effect of VC failure tolerance on startup innovation is much stronger when the failure risk is higher and thus failure tolerance is more needed and valued. For example, being financed by a failure-tolerant VC is much more important for ventures born in recessions or ventures at early development stages.

Practical steps

The results of the above studies suggest that firms can increase the efficiency of their corporate innovation by simply modifying its termination policies. For example, they can place employees involved in strategic innovation projects on fixed-term employment contracts (as opposed to employment-at-will). Alternatively, tenure-like positions may be created for the same employees.

Admittedly, capitalizing on the effects of international bankruptcy laws and VC investors’ tolerance for failure isn’t straightforward. However, firms should consider local bankruptcy codes when choosing the location of their innovation centers. And startup companies ought to be aware of the failure tolerance level of VC investors they choose.

A larger point, however, is that we must finally move from words to deeds when dealing with innovation failures. Providing people with immunity from failures is better than “celebrating” them.

The image was provided by Tatiana Ivanov

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Innovation and VC investors

Academic research provides abundant empirical evidence suggesting that corporate and socio-economic policies tolerating failure, both at individual and firm levels, foster innovation. For example, labor laws limiting firms’ ability to discharge employees at will were shown to stimulate corporate innovation. Corporate innovation is encouraged not only by protecting individual employees but the firms themselves, as evidenced by the finding that debtor-friendly (i.e., firm-friendly) bankruptcy laws have a positive effect on innovation output.

Yet another piece of evidence that the tolerance for failure positively affects corporate innovation comes from the work by Xuan Tian and Tracy Yue Wang published in 2011.

Tian and Wang studied the subject of innovation failures using an original empirical approach: by analyzing venture capital (VC) investors’ attitude towards failure in VC-backed startup firms. Startup firms are known to have high innovation potential, but also a substantial failure risk; thus, innovation failure tolerance is very important to them. On the other hand, VC investors’ tolerance for failure is crucial for the innovation productivity of VC-backed startups. If VC investors can’t tolerate early failures, they can prematurely liquidate a startup upon initial unsatisfactory progress and prevent it from realizing the startup’s true innovation potential.

Tian and Wang developed a practical measure of VC investor’s failure tolerance: they examined investors’ willingness to continue funding underperforming ventures (i.e., ventures not meeting pre-determined milestones). The rationale behind this approach is that when a project does not show progress towards its goals, a VC investor has a choice: to give the entrepreneur a second chance by continued funding or to write off the project immediately. What a choice the VC made would to some extent reflect their attitude towards failure. Other things equal, the longer the VC firm waits before terminating funding of underperforming projects, the more tolerant the VC is for early failures in investments.

Tian and Wang showed that IPO firms backed by more tolerant VC investors are significantly more innovative in terms of the quantity and quality of patents issued to them. (More specifically, if a VC firm on average invests for two years before terminating a project, but is willing to invest for additional two years in an IPO firm, then this IPO firm tends to have 40% more patents per year later.)

Tian and Wang also found that the effect of VC failure tolerance on startup innovation was much stronger when the failure risk is higher and thus failure tolerance is more needed and valued. For example, being financed by a failure-tolerant VC is much more important for ventures born in recessions, ventures at early development stages, and ventures in industries in which innovation is especially difficult (e.g., drug development). VCs’ tolerance for failure allows these startups to overcome early difficulties and realize their true innovation potential.

In my previous post, I described a Stanford study that shows that firms going for IPO may jeopardize their innovation output. In fact, going public can result in a 40% decline in the quality of patents issued to the IPO firm in the five years immediately following listing. Of course, this fact by itself shouldn’t prevent startups from considering IPO. However, they ought to be mindful of the consequences this development may have on their post-IPO ability to innovate—and they must adjust their corporate innovation policies accordingly. Choosing a “correct” (i.e., failure-tolerant) VC investor would be a smart move.

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Innovation and bankruptcy

Recently, I described academic studies suggesting that corporate innovation is fostered by labor laws that limit firms’ ability to discharge employees at will. These studies provide support to the idea that the best way to encourage risk-taking and experimentation is not to “celebrate failures,” but to remove the proverbial Sword of Damocles of punishment for them, something that any organization can do by modifying its termination policies.

It turns out that corporate innovation is encouraged not only by protecting individual employees but the firms themselves. In a paper published in 2009, “Bankruptcy Codes and Innovation,” Viral Acharya and Krishnamurthy Subramanian show that firm-friendly bankruptcy laws have a positive effect on corporate innovation.

Acharya & Subramanian have analyzed changes in bankruptcy codes that took part in 12 countries in 1978-2002. Over this period, seven countries (Canada, Finland, Indonesia, Ireland, India, Israel, and Sweden) have made their bankruptcy codes more debtor-friendly, i.e., favoring firms filing for bankruptcy. Five countries (Denmark, UK, Lithuania, Romania, and the Russian Federation) have made their country codes creditor-friendly, i.e., giving more rights to firms’ creditors.

Compared to a “control” group of counties—those that did not undergo a creditor rights change–the “treatment” group of five countries that underwent a firm’s rights decrease demonstrated a 9.7% decrease in the number of patents issued to these countries and a 13.3% decrease in their quality. In contrast, in seven countries where firm’s rights were increased, the number of patents rose by 10.7% and their quality by 15.4%.

There are two major factors contributing to creditor-friendly bankruptcy codes’ negative effect on innovation. First, they lead to the excessive liquidation of firms’ assets, which results in the reduction of funds available for innovation activities. Second, in countries with stronger creditor rights, innovative firms take smaller quantities of debt and keep more cash reserves, which again limits their ability to invest in innovative projects.

The major conclusion from the data presented by Acharya & Subramanian is that debtor-friendly bankruptcy codes encourage firm-level innovation by promoting the continuation of innovative activities even following the firm’s bankruptcy. Saying the same thing differently, very much like their employees, firms, too, need protection from failure.

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Innovation and IPO

Of all business processes, innovation is arguably the riskiest and most unpredictable; the rate of failure of innovation projects is shockingly high compared to other corporate programs and initiatives. Identifying factors that would make innovation more sustainable is therefore critical.

Business ownership is not a factor that comes to mind first when speaking about innovation. Yet available data suggest that it may play important role in the firm’s ability to innovate.

For example, although family-owned firms have smaller R&D budget than other firms of similar size (either public or private), they are more innovative as judged by the number of patents, new products, and revenues generated with new products.

Why? Because of family owners, who, due to their long relationship with the firm, have a deep knowledge of the industry, the firm, and its stakeholders. They spend considerable time with the organization and communicate frequently with employees, clients, and other stakeholders. Moreover, their close relationships with suppliers, customers, and other partners help family-owned firms develop more creative ideas, products, and processes.

Does that mean that the public ownership of a firm impedes its ability to innovate? Or, more specifically, does that mean that a firm going for IPO may jeopardize its innovation output? A research conducted by Shai Bernstein of Stanford shows that the answer to this question is (somewhat surprisingly) “yes.”

Bernstein compared firms going public with firms that were about to go public but held back because of market volatility (firms that filed the IPO registration with the Securities and Exchange Commission but later withdrew it for reasons unrelated to their innovation strategy and remained private). Innovation output was measured by using the number of patents granted to a firm and the number of future citations received by each patent. The former number captures the quantity of the firm innovation and the latter its quality.

The results of this comparison were striking: going public means a 40% decline in patent quality in the five years immediately following listing. Moreover, Bernstein found that following the IPO, the firms’ innovation becomes more incremental.

What happens? It turns out that the IPO event leads to an increased likelihood (18%, to be exact) of employees cashing out their stock and moving to new start-ups. This might not be a bad thing for the whole economy because innovation is still occurring, just at a different firm, but it’s definitely harmful to the newly-listed firm because employees who leave are likely to be exactly those who were responsible for the key innovation at the firm in the IPO pre-period.

An additional factor impeding innovation in the post-IPO firms is the stock market pressure which may dissuade managers from taking much risk and force them to pursue more incremental innovation.

Of course, concerns for the future innovation outcomes should not prevent firms going public. Yet they must be aware of its protentional consequences and adjust their innovation strategy and operations accordingly. For example, they may encourage future innovations by adopting optimal employee incentives that would include a combination of tolerance for failures in the short term and reward for success in the long term.

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The dose is everything: how much labor protection is good for innovation

theoretical concept proposed by Gustavo Manso in 2011 (I wrote about it here) postulates that the optimal combination of incentives that motivate employees to innovate must include tolerance for failure in the short term and reward for success in the long term.

This concept is supported by academic studies showing that corporate innovation is fostered by labor laws that limit firms’ ability to discharge employees at will. These studies provide empirical evidence to the idea that the best way to encourage risk-taking andexperimentation is not “celebrating failures,” but removing the proverbial Sword of Damocles of punishment for them, something that every organization can do by modifying its termination policies.

Do the above data mean that there is a proportional relationship between employee protection and firm innovation–the more, the better, so to speak? No, it appears that this relationship is rather “inverted-U-shaped.” That means that when the level of protection is too small, increasing it through the adoption of wrongful discharge laws (WDL) provides job insurance against failure risks, which spurs innovation. On the other hand, providing too much protection—forced, for example, by the trade unions–seem to stifle innovation instead.

The role that unions play in corporate innovation has been a topic of a considerable debate. It does appear that when worker’s jobs are protected with union membership, the workers feel more motivated to innovate. Besides, some data suggest that the declining numbers of people in unions contribute to income inequality, which in turn negatively affects innovation. These findings indicate that unionization may have some positive effect on corporate innovation.

However, empirical data contradict this hypothesis. In 2015, Daniel Bradley and co-authors published a paper where they analyzed how creating a union affects firms’ patent activity. The authors show that within three years following unionization, firms experienced an 8.7% decline in the number of patents and 12.5% decline in their quality. Among the factors leading to diminished innovation were a reduction in R&D expenditures caused by higher wages lobbied for by unions (a phenomenon described by other authors, too), reduced workers’ productivity, and departure of innovative employees.

The negative effect of unionization is evident in both manufacturing (where most unions form) and non-manufacturing industries but is statistically insignificant in firms located in states where unions have less bargaining power.

As they say, “the dose makes the poison.” It appears that this basic principle of toxicology is perfectly applicable to the effects of labor laws on innovation, too.

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The “labor law” of innovation

One might assume that pro-worker labor laws, due to their association with lower levels of investment, productivity and output, would have a negative effect on innovation. In fact, academic studies indicate that more stringent employment laws help firms and their employees pursue value-enhancing innovative activities.

The credit for pointing to a positive role labor laws play in the innovation process belongs to Viral Acharya of New York University Stern School of Business. In a 2010 paper, “Labor Laws and Innovation,” Acharya and co-authors explore how the legal framework governing the relationship between employees and their employers affect innovation output. The innovation output was measured by using the number of patents granted to a firm and the number of future citations received by each patent. The former number captures the quantity of the firm innovation and the latter its quality.

Acharya et al. first analyze the innovation output in five countries—the U.S., U.K., France, Germany, and India–which accounted for 72% of all patents filed with the USPTO between 1970 and 2006. This cross-country comparison shows that stronger labor laws positively correlate with a country’s innovation output. Interestingly, this effect is more pronounced in innovation-intensive industries, such as medical devices, than in more “traditional” industries, such as textile. Equally importantly, Acharya et al. find that the only dimension of labor laws that has a tangible impact on innovation is the “regulation of dismissal” component.

The authors further analyze the consequences of the WARN Act (Worker Adjustment and Retraining Notification Act), a federal law enacted by the U.S. Congress in 1988. The WARN Act requires most private employers with 100 or more employees to give a written notice to affected workers and local government 60 days before the date of a mass layoff or a plant closing. Employers who violate the WARN Act are liable for damages in the form of back pay and benefits to affected employees. The requirement of the Act increases the hurdles faced by employers when dismissing employees—and as such, have the same effect as dismissal laws. Acharya et al. show that the strengthening of dismissal laws via WARN had a positive impact on U.S. firm-level innovation: firms affected by WARN experienced increases in patents and patent citations by 43% and 71%, respectively, over the next five years when compared to firms that were not affected by WARN.

In a follow-up paper, “Wrongful Discharge Laws and Innovation,” published in 2014, Acharya and co-authors study the impact on innovation of the U.S. wrongful discharge laws (WDL). These laws provide employees with greater protection than employment-at-will, where employees can be terminated with or without just cause. The staggered passage of WDL across the U.S. states created a “natural experiment” assessing their impact on the innovation output. And this impact turns out to be quite impressive: the adoption of WDL results in a rise in the annual number of patents and patent citations by 12.2% and 18.8%, respectively, the effect starting to emerge two years after the WDL passage.

Moreover, the effect of WDL is evident not only at the firm but also at per employee level as evidenced by the increase of patents and patent citations by 12.3% and 19.0%, respectively, in states that adopted the laws vis-à-vis states that didn’t. As in the previous work, the positive impact on innovation is significant only in highly innovation-intensive industries.

Taken together, the data presented in both studies indicate that innovation is fostered by laws that limit firms’ ability to discharge their employees at will. Acharya and co-authors call this phenomenon an “insurance effect”: feeling increased protection from negative consequences of failure, employees are more committed to engaging in risky innovative projects.

These findings are fully consistent with a theoretical concept proposed, in 2011, by  Gustavo Manso (I wrote about it in my previous post) postulating 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 term.

They also strongly suggest that the best way to encourage risk-taking and experimentation is not to “celebrate failures,” but to remove the proverbial Sword of Damocles of punishment for them, something that any organization can easily do by modifying its termination policies.

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Innovation and failure: from words to deeds

The idea that innovation involves experimentation—and experimentation often results in failures–has gradually crawled to the forefront of our thinking about the innovation process. It became fashionable to quote Amazon’s Jeff Bezos as saying that high tolerance for risk and failure accounts for his company’s spectacular performance.

What troubles me in our newly-acquired passion for innovation failures is the deafening silence on the issue of how this positive attitude towards failure is to be promoted within organizations. We don’t send firefighters to extinguish fires without providing them with protective gear. We don’t send cops on the street without giving them tools of defense against dangerous criminals. Why then do we ask our employees to put their careers at risk by taking part in failure-prone innovation projects without assuring them that they won’t be punished should these projects fail?

I believe that instead of endless (and largely hollow) talks about “promoting risk-taking” and “celebrating failures,” we must design specific policies that would make it safe–or, better yet, attractive–for employees to engage in corporate innovation activities.

Academic research provides enough guidance with respect to what these policies should be. Theoretical analysis conducted by Gustavo Manso in 2011 showed that 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 term. 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 long-term success encourages the employees to explore risky ideas that may allow them to achieve innovation breakthroughs in more distant future.

Subsequent empirical studies have confirmed Manso’s theoretical reasonings. For example, Viral Acharya and co-authors analyzed the impact of the so-called wrongful discharge laws on corporate innovation. These laws provide employees with greater protection than employment-at-will when employees can be terminated with or without just cause. The authors have shown that the wrongful discharge laws, particularly those that protect employees from termination in bad faith, foster innovation by increasing the employees’ motivation and effort.

On the reward side, a recent work by Xin Chang and co-workers has provided evidence that companies offering stock options to non-executive employees are more innovative. The positive effect of stock option grants on innovation is more pronounced when options are granted to a wide range of employees and when the average expiration period of options is longer. Very importantly, the analysis reveals that the employees involved in innovation activities treat stock options as an incentive to risk-taking rather than an award for superior performance.

The above findings suggest that the firms should change they way they treat employees engaged in strategic innovation activities. Here, I want to offer two specific recommendations:

  1. To place employees involved in strategic innovation projects on fixed-term employment contracts (as opposed to employment-at-will). Alternatively, tenure-like positions may be created for the same employees. Whatever the arrangement, employees should be assured that they have a fixed “window of opportunities”—say, five-six years—to make progress in their projects before any administrative decisions regarding their employment will be considered.
  2. To make stock option grants the principal incentive for engagement in innovation projects–as opposed to cash bonuses and multiple non-monetary recognition and rewards.

I fully realize that the proposed recommendations will require firm-specific adjustments. But both are perfectly testable. Large firms may try an A/B test of sorts by implementing these specific policies in some divisions but not others and later comparing the innovation outcome in both groups.

The bottom line is that we must finally move from words to deeds when dealing with innovation failures. Providing people with immunity from failures is much better than “celebrating” them.

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