How incomplete contracts foster innovation in inter-organizational relationships

Relative to relational governance, research into the use and effects of formal governance is scarce. Recent contributions suggest that a specific type of contract that has intentionally been left incomplete, the performance-based contract (PBC), fosters innovation. However, it is unknown how this effect occurs. To address this gap, we draw on transaction cost economics and agency theory to develop propositions on how PBCs affect innovation. PBCs are characterized by low term specificity and rewards that are tied to performance. We propose that low term specificity, that is, not stipulating how the focal firm's partner should deliver the performance and which resources to use, enhances the partner's autonomy, which in turn fosters innovation. However, excessive low term specificity inhibits innovation, since it may lead the partner to display opportunistic behavior. We furthermore propose that performance-based pay incentivizes the partner to engage in innovation. This suggests that linking rewards to performance attenuates the negative relationship between term specificity and innovation when the former is very low. Finally, we propose that a more risk-averse partner will engage in fewer innovative activities as such a partner will be less sensitive to the pay-for-performance clause.