Developing new ideas: Spin-outs, spinoffs, or internal divisions

This paper proposes a theory of how employee-driven innovations are developed. An employee with private information about the value of his idea can create a spin-out, work in a division of the parent firm, or work for a spinoff of the parent firm. Developing an idea in a spinoff allows the parent firm to offer a performance-based contract, which mitigates the adverse selection problem but also decreases the firm's incentives to invest in the project. Therefore, inefficient spin-outs are driven by the informational asymmetry and the endogenous investment of the parent firm. The characteristics of the innovation, the employee's managerial talent, and the firm's performance in its core activity affect the likelihood a spin-out is created. The implementation of employees' ideas in turn affects the innovation process. Ideas with a lower probability of being good are more likely to be explored by an employee within the firm than by an outsider.