Employee treatment and firm innovation

• Author: Connie X. Mao,Jamie Weathers
• DOI: http://doi.org/10.1111/jbfa.12393
• Published date: 01 July 2019
• Date: 01 July 2019

DOI: 10.1111/jbfa.12393

Employee treatment and firm innovation

Connie X. Mao1Jamie Weathers2

1FoxSchool of Business, Temple University,

Philadelphia, USA

2Department of Finance and Commercial Law,

Haworth College of Business, WesternMichigan

University, USA

Correspondence

ConnieX. Mao, Department of Finance, Fox

Schoolof Business, Temple University,Philadel-

phia,PA 19122.

Email:cmao@temple.edu

Abstract

We identify firm innovation as a channel through which the treat-

ment of employees affects firm value. Long-term incentive theory

supports positive effects of ‘good’ employee treatment on innova-

tion. Alternatively, entrenchment theory suggests such treatment

will lead to complacency and shirking, hence deterring innovation.

These opposing views merit investigation since human capital is

increasingly essential to the growth and success of a firm. Using the

KLD database and patent/citationdata, we find a significant positive

relationship between favorable employee treatment and the inno-

vation quantity and quality of a firm. Furthermore, we find that the

positive treatment of employees improves innovation focus – more

innovation related to firms’ core business, leading to greater firm

value via the increased economic value of patents. These findings,

robust to endogeneity concerns, provide support for the long-term

incentive hypothesis, suggesting that well-treated employees

increase firm innovation. Thus, firm innovation represents a channel

through which positive employeetreatment enhances firm value.

KEYWORDS

corporate social responsibility (CSR), employee treatment, human

capital, patents and citations, technological innovation

JEL CLASSIFICATION

G3, J24, M14, O31

1INTRODUCTION

It is often contended that employeesare the most valuable asset of a firm and an essential source of competitive advan-

tage (Coff,1997). This is particularly true with respect to firm innovation. For example, Laszlo Bock, former Senior VP

of Google’s People Operations, commented on Google’s aptitude for creating an environment of innovation through

employee empowerment:

Google has been keeping the pipeline of innovation going by tapping its employees and letting ideas percolate

up …Personally,I believe this culture is an insight about the human condition. People look for meaning in their

J Bus Fin Acc. 2019;46:977–1002. wileyonlinelibrary.com/journal/jbfa c

2019 John Wiley & Sons Ltd 977

978 MAO ANDWEATHERS

work. People want to know what’s happening in their environment. People want to havesome ability to shape

that environment.1

This approach to a ‘cultureof innovation’ is necessary for firm survival as it is a strong source of competitive advan-

tage(Zingales, 2000). However, a central challenge in motivating employees arises when the interests of employeesand

thefirm are misaligned, and the efforts of employees cannot be perfectly observed. These circumstances create a moral

hazard problem where employees may haveincentives to exert low levels of effort to enjoy the ‘quiet life’ (Bertrand &

Mullainathan, 2003).

Researchers have focused on the design of monetary incentives, linking employee compensation to firms’ eco-

nomic outcomes via performance pay to mitigate the moral hazard problem between employees and the firm

(Holmstrom, 1979). However, monetary incentives often provide only relatively weak association between pay

and performance due to concerns about inequality and overconfidence (Larkin, Pierce, & Gino, 2012). Further,

employees are only motivated by monetary incentives up to a certain point, beyond which non-pecuniary incen-

tives, such as fair treatment and job satisfaction, are required to generate more firm value (Cerasoli, Ford, &

Nicklin, 2014). Building on recent literature in which a firm’s treatment of its employees affects the value of

the firm – either directly through shareholder value (e.g., Edmans, 2011; Faleye & Trahan, 2011) or indirectly

via capital structure (e.g., Bae, Kang, & Wang, 2011; Berk, Stanton, & Zechner, 2010; Verwijmeren & Derwall,

2010) – we propose corporate innovation as a new channel through which employee treatment affects firm

value.

In this paper, we investigate the effect of employee treatment on firm innovation, based on the literature and

prevailing views. There are two opposing views of the effect. The first view is that positive employee treatment

enhances firm innovation. Many of the components in positive employee treatment (or satisfaction) are conducive

to a corporate culture of failure tolerance, exploitation protection, and an engaging work environment. Innova-

tive projects typically involve high risk, long-term horizons, and often many failures before successes. Job secu-

rity often promotes a failure-tolerant work environment, which in turn provides motivation for employees to inno-

vate (i.e., participate in tasks with a high probability of failure) (Manso, 2011). Exploitation protection represents

a positive culture of managerial ethics and integrity, which in turn reduces the fear of being exploited or having

ideas expropriated, hence encouraging employees to invest more in firm-specific human capital to develop inno-

vative projects (Carmeli, Reiter-Palmon, & Ziv, 2010). Finally, a favorable work setting reflects an environment

focusing on teamwork and citizenship. Innovation often involves collaboration, whereby a corporate culture of

good teamwork and respect will foster productive collaborations, thus enhancing innovation (Folkestad& Gonzalez,

2010).

The second view is that positive employeetreatment may hinder innovation. Cronqvist, Heyman, Nilsson, Svaleryd,

and Vlachos (2009) suggest that entrenched managers receive private benefits such as fewer union negotiation

attemptsand better social relationships with employees by paying workers more. As a result, favorable employeetreat-

ment may be conducive to a work environment where both managers and employees enjoy the ‘quietlife’. Similarly,

union-controlled firms via employee stock ownership plans (ESOPs) tend to enhance participants’ personal benefits

rather than maximizing shareholder value (Faleye, Mehrotra, & Morck, 2006). Further, Atanassov (2013) documents

that job security due to anti-takeover laws causes a lower levelof firm innovation. Consequently, favorable employee

treatment could deter firm innovation.

To study the impact of positive employee treatment on firm innovation, we employ data from two independent

sources as employee treatment proxies: the KLD Research & Analytics, Inc. SOCRATESdatabase (KLD) and Fortune’s

100 Best Companies to Work For R

lists (the Best Companies list or BC list). We use patent and citation information

1http://www.forbes.com/sites/laurahe/2013/03/29/googles-secrets-of-innovation-empowering-its-employees/.