Contracting for innovation: Designing contracts that account for exchange hazards and the need for innovation

Abstract

Research Summary: We examine how organizations govern interfirm transactions that involve innovative tasks. Designing contracts that foster innovation is challenging and becomes more complex when exchange hazards are present. We draw on regulatory focus theory to examine the effects of promotion and prevention effects in contract framing contracts to address how firms should design their contracts to balance the need for promoting innovation and protecting against opportunistic behavior. Using a sample of contracts from the information technology services industry, we find that in the presence of exchange hazards, task innovation involves hybrid payment systems, less use of detailed description of requirements, and more use of extensive contingency planning. Managerial Summary: Managers must understand how contract design can aid in the success of interfirm innovation endeavors as radical innovation is frequently developed in an interfirm context. Our findings suggest that contract negotiators should pay special attention to several contractual elements when designing contracts for tasks that require more radical innovation. In particular, the payment structure, specifications of outcomes and processes, and contingency planning clauses influence the innovative output of suppliers. Employees who understand the task should participate in contract negotiation and design, allowing them to outsource more innovative tasks and manage them more effectively.