Purpose While anecdotal evidence suggests that performance-based contracts (PBCs) may foster innovation in buyer-supplier relationships, the understanding of the underlying mechanisms is limited to date. The purpose of this paper is to draw on transaction cost economics and agency theory to develop a theoretical model that explains how PBCs may lead to innovation. Design/methodology/approach Using data on 106 inter-organizational relationships from the Dutch maintenance industry, the authors investigate how the two main features of PBCs – low-term specificity and performance-based rewards – affect incremental and radical innovation. Findings The authors find that term specificity has an inverse-U-shaped effect on incremental innovation and a non-significant negative effect on radical innovation. Furthermore, pay-for-performance has a stronger positive effect on radical innovation than on incremental innovation. The findings suggest that in pursuit of incremental innovation, organizations should draft contracts with low, but not too low, term specificity and incorporate performance-based rewards. Radical innovation may be achieved by rewarding suppliers for their performance only. Originality/value The findings suggest that in pursuit of incremental innovation, organizations should draft contracts with low, but not too low, term specificity and incorporate performance-based rewards. Radical innovation requires rewarding suppliers for their performance only.

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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 performancebased 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.

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