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Options NOT ownership equal innovation

9 June 2016

The article at a glance

If you want employees to innovate you give them ownership, right? Wrong. New research suggests that offering stock options, rather than shares, …

If you want employees to innovate you give them ownership, right? Wrong. New research suggests that offering stock options, rather than shares, to rank and file employees boosts innovation – while ownership might actually reduce it.

Options NOT ownership equal innovation

In tricky economic times, with digital technologies disrupting almost every market sector, private companies must innovate to thrive and grow. Some have tried using technology to improve collaboration and productivity and create an environment where innovation is more likely. Some have tried altering working patterns and premises.

It seems there is no magic bullet to boost innovation. But it turns out there may be one step companies can take that will definitely help: offering stock options to a broad range of non-executive employees.

Xin (Simba) Chang
Xin (Simba) Chang

Stock options have been used as an employee benefit for years, but usually as a performance incentive, offered most often to executives. But research produced by a team led by Dr Xin Chang, University Senior Lecturer in Finance at Cambridge Judge Business School, shows that widespread distribution of stock options among non-executive employees boosts innovation. In part this is because ownership of stock options encourages risk-taking while also encouraging employees to work for the long term good of the company. By contrast, stock ownership can lead to more conservative behaviour from employees – and therefore less innovation.

“Use of stock options has a totally different impact on innovation compared to stock ownership,” says Dr Chang. “With ownership employees don’t want to take too much risk because stock values decrease with risk. But employees take more risk in innovation if you give them stock options because option values increase with risk. That promotes innovation.”

Drawing on existing research, Dr Chang’s team identified additional reasons why this would be the case. Innovation is often the result of long term projects; and stock options encourage employees to commit to their employer until those options become exercisable. Finally, innovation often depends on teamwork. Existing research shows that group incentives encourage co-workers to support and monitor each other and to share information freely.

So, through encouraging risk-taking, commitment to the success of the company and more effective teamwork, non-executive employee stock options help to create an innovation-friendly environment.

The team drew upon data held in the (US) National Bureau of Economic Research (NBER) Patent and Citation Database; and valued stock options using data from the Investors Responsibility Research Center. They found a positive association between the value of stock options per employee and the quantity and quality of innovation output in terms of the numbers of patents and patent citations.

They then tested these results by considering other variables that could also drive innovation, related to financial constraints, corporate governance, or geographic clustering of similar companies. They took into account the fact that some firms may use stock options to reward or retain employees who have already proved an ability to generate innovation. The results withstood all these tests.

Their analysis also showed a more pronounced relationship between stock options and innovation in firms that attained a higher score on an employee treatment index and spent more on R&D per employee. This showed the positive effects of option ownership on innovation were stronger if employee input was seen to be more important within those firms.

Because innovation benefits companies over the long term, the team also expected and confirmed that the longer the term of expiration of the options, the more positive the effect on innovation. “It takes many years to see a commercial product emerge from the R&D process, so the innovator needs a long term perspective,” Dr Chang explains. “Options serve this purpose really well, because there is a long vesting period during which, if you leave, the value of the option will be gone.”

The data suggests that stock ownership encourages employees to work hard, but can discourage the risk-taking that boosts innovation. This is because innovation increases employees’ exposure to risks associated with volatility. But volatility can increase the value of stock options. “If you’re a stockholder you don’t want volatility, because it means risk,” says Dr Chang. “But innovation is primarily about risk-taking. So stock options are a better incentive device for innovation.”

He believes the positive effect of employee stock options on innovation is clearly visible in the technology sector; in companies such as Google. “Google believes everybody is a contributor to innovation, so that’s why they need these incentives – but they are very cautious in giving employees ownership, because they want them to remain innovative.”

Broad employee ownership of stock options is also well-suited to start-ups. “By definition they are very innovative and they want to incentivise employees but don’t have much cash,” Dr Chang explains. “So they can give employees options and save cash for other investments.”

But this research is relevant to any company that values innovation, Dr Chang suggests, citing the positive effect of option ownership on innovation for manufacturers like Whirlpool in the past. “If you give stock to employees they will still work hard, but when they come to choose between different innovation strategies they may take the safer choice,” he says. “Then, in the longer term, in growth and competitive strength, the company may suffer because it will become less innovative.”

The conclusion is clear: if a business owner wants more innovation, they should offer more employees stock options, to help encourage risk-taking while deepening their commitment to the company. It’s a strategy that could also deliver significant value to the company’s shareholders and customers over the longer term.