Fostering Innovation Through Performance Based Contracts
Fostering Innovation through Contracting in Inter-Organizational Relationships
Regien Sumo, PhD
Although studies have shown that inter-organizational relationships (IORs) enhance and even drive innovation, according to transaction cost economics (TCE) and agency theory (AT), the IOR may suffer from opportunistic behavior or coordination failures that impede the efforts of even well-intentioned parties. Formal governance (i.e., contracts) and relational governance (i.e., trust) are both viewed as important governance mechanisms that safeguard IORs from opportunistic behavior and failures. However, compared to relational governance, there is scarce research on the effects of contracts on innovation.
Nevertheless, researchers do agree on and have suggested that performance-based contracts (PBCs), which have intentionally been left incomplete and are predominantly used in the context of partnering with an organization that delivers services, allows room for the partner to engage in innovation. PBCs are contracts that underline the outcome of the transaction rather than prescribing how to perform the transaction or which resources to use. Though several authors have acknowledged the positive effects of such contracts on innovation, none of the research empirically studies how this effect occurs. Moreover, studies rarely link contracts to positive performance outcomes. Thus, the question of how (incomplete) contracts, such as PBCs, affect innovation in inter-firm settings is insufficiently answered. This dissertation contributes to this debate by focusing on PBCs as a specific type of incomplete contract and develops and empirically tests a conceptual model that explains how the characteristics of PBCs affect innovation. In addition, despite the increasing importance of relational governance in IORs when using incomplete contracts and the large amount of research on contracts and trust, there is little consensus on the relationship between trust, contracts, and innovation. More specifically, contracts and trust have not been viewed in terms of their necessity, i.e., are they both necessary, but not sufficient, conditions for innovation, and in which combinations are they necessary for certain degrees of innovation. Therefore, this dissertation presents four studies on how to successfully engage in innovation by using formal and relational governance mechanisms. The research questions of this dissertation were formulated as:
Research Question 1: To what extent do PBCs affect innovation in IORs?
Research Question 1A: What are the main characteristics of PBCs?
Research Question 1B: How can the relationship between PBCs and innovation in IORs theoretically be explained?
Research Question 1C: How can the relationship between PBCs and innovation in IORs empirically be explained?
Research Question 2: Which combinations of contracts and trust are
necessary for achieving innovation in IORs?
Given that existing research has not focused on the effects of PBCs on innovation, it was necessary to build a preliminary conceptual model that shows how existing governance, management and innovation literature and theories could explain the relationship between incomplete contracts, such as PBCs, and innovation. Hence, the first study’s (chapter 2) objective was to identify the key characteristics of PBCs and develop a conceptual model that identifies how existing literature and theories can explain the relationship between these characteristics and innovation by means of an extensive literature review.
The study showed that PBCs are characterized by low term specificity in comparison to behavior-based contracts, which prescribe the resources and the delivery. Second, PBCs reward the partner for its performance (pay-for-performance). TCE and AT were then used to explain how these contractual characteristics affect innovation. TCE proposes that the IOR can be protected from opportunism by the degree of contractual completeness, and AT focuses on the way the partner is rewarded. TCE suggests that low term specificity gives
the partner the autonomy to decide how to attain the performance goals, and control over the processes and procedures of their own work, which in turn results in innovative activities. However, excessive low term specificity creates the potential for the partner to act opportunistically, resulting in an overall lower quality and value of the innovative activities. Moreover, it was also argued that a too high degree of term specificity is detrimental for innovation. Furthermore, it was argued that when the partner is paid for performance, it is incentivized to behave in the interest of the focal firm and engage in innovation activities. Thus linking rewards to performance positively affects innovation. Finally, it was postulated that, all else being equal, the more a risk-averse the partner, the less it will engage in innovative activities as the partner will be less sensitive to the pay-for-performance clause.
In addition, to empirically refine the conceptual model study 2 (chapter 3) made use of two cases of performance-based IT-service contracts. The most important finding of this study was related to term specificity. It was observed that low term specificity in the contractual design phase which should provide autonomy is not sufficient for innovation: it appears to be the granted autonomy that allows the partner to use their knowledge and experience to optimize the service process. Thus, even though existing theory argues that a low degree of term specificity provides autonomy to engage in innovative activities, if the spirit of the contract is not followed and the focal organization does not provide this autonomy, innovation will not occur.
To answer the main research question, study three (chapter 4) empirically tested the relationship between the characteristics of PBCs and incremental and radical innovation by means of a survey-based research approach, whereby data was collected from 106 buying and selling organizations active in the Dutch maintenance industry.
The results show that term specificity affects incremental and radical innovation differently. Term specificity is inverse-U related to incremental
innovation, meaning that term specificity should neither be too high nor too low to achieve the highest possible level of incremental innovation. On the other hand, this effect was not found for radical innovation. Rather, term specificity negatively affects radical innovation. Second, the results showed that pay-for-performance positively affects both incremental and radical innovation. Moreover, the effect of pay-for-performance was found to be stronger for radical innovation than for incremental innovation. Third, it was found that the partner’s degree of risk-aversion positively rather than negatively moderates the relationship between pay-for-performance and incremental and radical innovation. This means that under pay-for-performance conditions, a risk-averse partner will engage more strongly in incremental and radical innovation. This is in contrast to the expectations identified in studies 1 and 2 that risk-aversion would have a negative moderation effect. This finding may be explained from the relatively higher pressure that risk-averse partners compared to non risk-averse partners experience under the presence of a pay-for-performance clause. Under such conditions, risk-averse partners will experience pressure to succeed, because the consequences of not meeting performance targets could have serious financial consequences. Such pressure drives organizations to place a greater value on creative ideas and, thus, to act on the outcomes of a creative climate. As a result, risk-averse partners will deploy more conscious decision-making and devote their most valuable resources to offset the risks they are confronted with and to obtain the rewards involved. It was also found that this moderation effect is stronger for radical innovation than for incremental innovation.
The final research question of which combinations of contracts and trust are necessary for achieving a certain degree of innovation was answered in study 4 (chapter 5) by using the necessary condition approach (NCA) to analyze data on 48 IORs in the Dutch maintenance sector. The results showed that contractual detail, goodwill trust, and competence trust are all necessary conditions for innovation; the three conditions (to some extent) must be in place to even allow for (a certain level of) innovation. The findings suggest that contracts and trust are complements in explaining innovation. This study also added more detail to the analysis by considering the levels of contracts, goodwill trust, and competence trust in combination and identifying the required levels of each of the three conditions given a certain desired level of innovation. The four variables were split into three categories, i.e., low, medium, and high. For low levels of innovation, none of the conditions is a bottleneck. Organizations pursuing a medium innovation require no to almost half of the maximum level of goodwill trust, no to about two-fifths of the maximum level of competence trust, and very low to about two-fifths of the maximum level of contractual detail. Organizations that aim for high innovation levels need at least two-thirds of the maximum level of goodwill trust, at least more than half of the maximum level of competence trust, and at least almost half of the maximum level of contractual detail. If any of these levels is not met, this high level of innovation will not be achieved. Note that not meeting the threshold of a condition cannot be compensated by another condition.
Finally, chapter 6 summarized the main findings of the four studies and provided an integrated perspective by showing the commonalities between the separate studies. It also showed the practical implications of this dissertation. Overall, the first three studies showed the importance of three stages of engaging in IORs when organizations want to stimulate innovation: the partner selection phase, the contract design phase, and the contract execution phase. In the partner selection phase, organizations should select those partners according to their risk-preference in terms of engaging in innovation when a pay-for-performance clause is present. Hence, there should be a sound partner evaluation and selection process incorporated prior to contracting the partner. Second, in the contract design phase, both parties in the IOR should not consider contracts only as a safeguarding mechanism. Rather, they should realize that the way they structure the contract also has an effect on outcomes such as innovation. Depending on what type of innovation they want to achieve, they should carefully design the term specificity and the partner’s reward scheme. In addition, it also becomes important to involve not only legal employees during the contract design phase because important knowledge regarding roles and responsibilities to include in the contract (i.e., degree of term specificity) often resides outside of the legal department of the firms involved (Argyres & Mayer, 2007). Lawyers are less likely to be a crucial part of the relationships that develop at the operating level, and are thus less likely to have the knowledge possessed by the employees who are involved in the day-to-day operation of the IOR (Argyres & Mayer, 2007). The parties should also involve employees who will be involved in the day-to-day operations of the IOR. This dissertation also acknowledged the role of relational governance. It showed the importance of contracts and trust in achieving high levels of innovation. When an incomplete contract is implemented, relational governance becomes extremely important.
In sum, this dissertation has provided empirical evidence for the importance of formal and relational governance mechanisms in IORs. The studies have shown that formal governance is no longer seen as only mitigating risks that accompany IORs. Rather, despite the fact that scholars have emphasized the role of trust and have questioned the role of contracts, this dissertation shows that contract design and contract execution in combination with trust has a significant effect on IOR outcomes. Hence, there is an important task for managers to make the trade-off between more or less contractual detail, goodwill trust and competence trust for achieving innovation. Depending on their level of ambition and which type of innovation (i.e., incremental or radical) they want to pursue, they have to carefully optimize their formal and relational governance mechanism, since different level and type of innovation require different levels of contractual detail and trust.
About the Author
Regien Sumo was born in Zakho, Iraq, on May 15, 1988. After obtaining her bachelor’s degree in International Business at Tilburg University (The Netherlands), she studied Strategic Management and Finance at Tilburg University. During her master’s year, she also studied Financial Investments at the University of California, Berkeley. In 2011, she graduated ‘Cum Laude’ for her Master of Science within the School of Economics and Management at Tilburg University on the topic of ‘Corporate venture capital and real option valuation’. In October 2011, Regien started her Ph.D. project in the Innovation, Technology Entrepreneurship & Marketing (ITEM) group of the school of Industrial Engineering at Eindhoven University of Technology (The Netherlands) of which the results are presented in this dissertation. Her work has been published in numerous renowned international conference proceedings, such as AoM (2012, 2014), IPSERA (2012, 2013, 2014), and ICIM (2012) and are now under review at high-quality ISI rated journals. The resulting paper of the study in chapter 4 has been published in the ‘Best Paper Proceedings of the Academy of Management Conference 2014’ and has won the ‘Best Paper Award’ at the IPSERA 2014 Conference. In the fall of 2013, Regien was a visiting scholar at the Zicklin Business School, University of New York, USA.