Freedom to Fail, Freedom to Innovate

Everyone seems to agree that innovation is a risky business: it involves a lot of experimentation, which often ends up in failure. High tolerance for failure therefore can be considered as a major prerequisite for any successful innovation program.

While talks about accepting or even “celebrating” failures are becoming commonplace, little attention is being paid to how positive attitude towards failure should be promoted. Which specific policies could be put in place to make safe–and, better yet, attractive–for firms and their employees to engage in innovation activities?

The “Labor Law” of Innovation

Academic research provides useful guidance with respect to what these policies should be. Theoretical analysis by Gustavo Manso suggests that conditions incentivizing employees to innovate must include tolerance for early failures, which would allow them to take risks at the initial stages of the innovation process without facing negative consequences of failed projects.

Available empirical evidence supports Manso’s conclusion. For example, an analysis of the impact of labor laws on innovation in five countries showed that stronger labor laws positively correlated with a country’s innovation output. In another study, the impact on innovation of the U.S. wrongful discharge laws (WDL) was investigated. These laws provide employees with greater protection than employment-at-will, under which they can be terminated with or without just cause. The WDL, particularly those that protect employees from termination in bad faith, were found to foster innovation by increasing the employees’ motivation and effort.

These results strongly suggest that innovation is promoted by laws that limit firms’ ability to discharge employees at will. Experts call this phenomenon an “insurance effect”: feeling increased protection from negative consequences of failure, employees are more committed to engaging in risky innovative projects.

Innovation and Bankruptcy Laws

It turns out that corporate innovation is encouraged not only by protecting individual employees but the firms, too. A study of bankruptcy laws in 12 countries showed that more debtor-friendly bankruptcy codes (i.e., codes favoring firms filing for bankruptcy) had a positive effect on corporate innovation. The debtor-friendly laws encourage firm-level innovation by promoting the continuation of innovative activities even following the firm’s bankruptcy.

Innovation and Investment

Another piece of evidence that tolerance for failure positively affects corporate innovation comes from a study investigating how venture capital (VC) investors deal with failures of startup firms they fund. Startups have high innovation potential, but they also carry a substantial risk of failure; innovation failure tolerance is therefore very important to them. That’s why VC investors’ own tolerance for failure is crucial. If they can’t tolerate early failures, they would prematurely liquidate a startup upon initial unsatisfactory progress and thus prevent it from realizing the startup’s true innovation potential.

The study shows that startups backed by more tolerant VC investors are significantly more innovative. The effect of VC failure tolerance on startup innovation is much stronger when the failure risk is higher and thus failure tolerance is more needed and valued. For example, being financed by a failure-tolerant VC is much more important for ventures born in recessions or ventures at early development stages.

Practical Steps

The results of the above studies suggest that firms can increase the efficiency of their corporate innovation by simply modifying its termination policies. For example, they can place employees involved in strategic innovation projects on fixed-term employment contracts (as opposed to employment-at-will). Alternatively, tenure-like positions may be created for the same employees.

Admittedly, capitalizing on the effects of international bankruptcy laws and VC investors’ tolerance for failure isn’t straightforward. However, firms should consider local bankruptcy codes when choosing the location of their innovation centers. And startup companies ought to be aware of the failure tolerance level of VC investors they choose.

A larger point, however, is that we must finally move from words to deeds when dealing with innovation failures. Providing people with immunity from failures is better than “celebrating” them.

Image provided by Tatiana Ivanov

About the author

Eugene Ivanov writes about crowdsourcing, open innovation and innovation in general. He blogs at Innovation Observer, edits monthly newsletter on crowdsourcing “We the People of the Crowd” and tweets @eugeneivanov101.