Pay-For-Performance Compensation Limits Innovation

Angry calls to limit executive compensation and impose pay-for-performance schemes may be an understandable response to the global financial downturn.

But Gustavo Manso, assistant professor of finance at MIT's Sloan School of Management, argues that such punitive action isn't the rational way to encourage the innovation upon which our economy depends.

In three recent research papers -- one co-authored by Florian Ederer, assistant professor at UCLA Anderson School of Management, another co-authored by MIT assistant professor Pierre Azoulay and Columbia University associate economics professor Joshua Graff Zivin -- Manso asserts that, among businesses on experimentation for innovation, incentives that don't penalize failure and promote long-term success lead to more innovative business strategies than fixed-wage or pay-for-performance incentives.

In one paper, "Is Pay-For-Performance Detrimental To Innovation?," Manso and Ederer describe the results of a commerce experiment conducted with three groups operating lemonade stands.

The first group received a fixed wage. The second group received a pay-for-performance contract that gave them 50% of profits over 20 sales sessions. The third group received a contract designed to promote exploration that awarded them 50% of profits generated only during the last 10 sales sessions out of 20.

The latter two groups were told the experiment would be called off if they weren't generating sufficient profits. But the third group also was told it would receive a termination bonus if that happened.

The results of the experiment appear to answer the question posed by the paper's title in the affirmative. Those in the third group, the group encouraged to explore by a contract designed to steer clear of penalties for failure, ended the experiment with the best location for their lemonade stand 80% of the time. The groups operating with a fixed-wage contract and with a pay-for-performance contract ended the experiment with the best location only 60% and 40% of the time, respectively.

In an e-mail, Manso said that the results deal with compensation policies, rather than the level of compensation that's appropriate.

"They show that compensation schemes that tolerate early failure and reward long-term success promote innovation," he said. "One way to implement such compensation scheme is with the combination of golden parachutes and long-term stock options. Therefore, policies that restrict the use of some of these instruments may have adverse effects on innovation."

In addition to golden parachutes, Manso said that tenure and debtor-friendly bankruptcy laws are other examples of compensation schemes that promote exploration and innovation by shielding people from potential failure.

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