Motivating Innovation

Motivating innovation is an important concern in many incentive problems. For example, shareholders of large corporations often need to motivate managers to pursue more innovative business strategies. This paper shows that the optimal incentive scheme that motivates innovation exhibits substantial tolerance (or even reward) for early failure and reward for long-term success. Moreover, commitment to a long-term compensation plan, job security, and timely feedback on performance are also essential ingredients to motivate innovation. In the context of managerial compensation, the optimal incentive scheme that motivates innovation can be implemented via a combination of stock options with long vesting periods, option repricing, golden parachutes, and managerial entrenchment. ∗MIT Sloan School of Management, 50 Memorial Dr E52-446, Cambridge, MA 02142 (e-mail: [email protected], url: www.mit.edu/∼manso/). I thank John Roberts, Anat Admati, Darrell Duffie, and Ed Lazear for valuable discussions and suggestions. I also thank Peter DeMarzo, Bob Gibbons, Thomas Hellman, Bengt Holmstrom, Jim March, Pedro Miranda, Stew Myers, Tomasz Sadzik, Maria Salgado, Yuliy Sannikov, Antoinette Schoar, Andy Skrzypacz, Ilya Strebulaev, Alexei Tchistyi, Jeff Zwiebel and seminar participants at Berkeley, Chicago, Columbia, Duke, FGV, Harvard, LBS, LSE, MIT, Northwestern, NYU, Princeton, PUC-Rio, Stanford, UCLA, UCSD, UIowa, University of Oregon, and UPenn for helpful comments and Forrest Funnell for outstanding research assistance. Financial support from a Stanford Institute for Policy Research (SIEPR) Fellowship and the Lehman Brothers Fellowship for Research Excellence in Finance is gratefully acknowledged.