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Do Compensation Systems for Employee Inventions
Increase Incentives for Researchers?
－Evidence from Japanese Panel Data－
Research Fellow: Koichiro OnishiThis research empirically analyzed whether compensation systems for employee inventions that are
currently implemented by companies actually lead to R&D results. A detailed questionnaire survey, targeting
310 manufacturing companies listed on the first section of the Tokyo Stock Exchange, was conducted about thestatus of implementation of compensation systems for employee inventions. This was in order to investigate
whether such compensation systems have a positive effect on the number of US patents and the number ofpatents adjusted for the number of forward citations. Estimation results revealed that both compensation
systems based on overseas filing/registration and compensation systems based on performance such as sales androyalty income are effective in increasing the number of US patents, but that they do not contribute to increasing
the number of patents adjusted for the number of forward citations. This outcome indicates that compensation
systems for employee inventions are effective in increasing the number of patents rather than increasing thequality of patents. In other words, it suggests that compensation for employee inventions is effective to a certain
extent as performance-based pay but that this effect is limited.

Ⅰ Introduction
The purpose of this research study is toquantitatively grasp the outline of compensation
systems for employee inventions that are
currently implemented by companies, and thenempirically analyze whether such systems
actually lead to better R&D results.
Since most patent applications currently
pending are filed by organizations such ascompanies and universities, the issue of
incentives for researchers in employment tocreate inventions is extremely important.
However, while R&D incentives for companies
have been frequently addressed in theoretical andempirical analyses so far, incentive systems forresearchers employed by companies have not yet
been sufficiently studied.(*1) Recently, along with
the increasingly high level of R&D, the funding
and resources supplied by companies havebecome increasingly important. Nevertheless,incentives for researchers who are directly
involved in the process of making inventions arestill critical to R&D.
The Japanese Patent Law provides thatcompanies shall pay a “reasonable remuneration”
for inventions transferred from their employees
who have made the inventions. Therefore, many
Japanese companies implement compensation

systems to provide compensation for each
invention based on its performance. In particular,
due to the recent increase in the number oflawsuits filed by employees for a “reasonable
remuneration,” the number of companies that
implement compensation systems for employee
inventions as a means to avoid such lawsuits is
also increasing.
The purport of this legal provision on
employee inventions is to compensate inventors
with a part of the profits arising from theinventions in order to motivate them to makethose inventions, thereby contributing todevelopment of industry, which is the primary
purpose of the Patent Law.(*2) Furthermore, as
performance-based salary systems have recently
been introduced for various types of occupations,companies could benefit from implementing
performance-based
compensation
systems,irrespective of whether the law requires such
systems.
However, there are some factors that might
prevent compensation systems for employee
inventions from producing the expected effects.
According to the standard contract theory, at least,
the higher the uncertainty regarding inventions
or evaluation risk, the less effective theperformance-based pay.
Based on the above, this research study(*1) Agihon and Tirole (1994), an exceptional study.
(*2) Refer to the statements of JPO Commissioner Shinichiro Ota at the Commission on Economy and Industry of theHouse of Representatives on November 8, 2002.

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analyzes statistically whether compensation
systems for employee inventions increase
incentives for researchers and contribute to thecompany’s success.

Ⅱ Effectiveness of Compensation
Systems for Employee Inventions
Compensation for employee inventions is
paid based on research results achieved byindividual employees and therefore can be
regarded as a kind of performance-based pay.
According to contract theory, an effective
way of motivating employees is to pay themsalary based on performance in addition to a fixedsalary. Therefore, in order to secure highlymotivated employees, companies will findincentives to implement performance-based salarysystems. In order words, if companies could
benefit by paying researchers salary based on
performance, they would implement performancebased compensation systems, irrespective of theprovisions of Section 35 of the Patent Law.
However, as mentioned above, implementing
performance-based salary systems in the R&D
field may not be beneficial from the perspective ofcontract theory due to the following factors.
The first factor is the very high uncertainty
of inventions. According to the standard contract
theory, if performance risk is high, increasing theamount of a fixed salary is more beneficial to bothcompanies and employees than paying a salary
based on performance, because as long as
employees have the tendency to avoid risk, thenthe higher the uncertainty, the lower the marginalutility of the performance-based salary system.(*3)
Also, such a salary payment system susceptible
to uncertainty is not as beneficial to companies asmight be expected.(*4)
In reality, only a limited number of
researchers are so productive as to file many
patent applications. It is said that the number of

researchers who obtain patents during a certain
term, n, decreases in proportion to 1/n2 according
to Lotka’s Law (Narin and Breitman, 1995).
Furthermore, there exists a considerable variationin respect of the value of patents; 10% of allpatents account for 90% of the total value (Scherer
and Harhoff, 2003). In the pharmaceutical field, it
is extremely difficult to develop commercial drug
products from R&D results, and most researchers
are unable to develop commercial products andmake little contribution to profits before they end
their careers in pharmaceutical companies. In
addition, whether patents actually contribute tosales or profits largely depends on the quality ofother related inventions and marketing efforts,
which are out of the control of inventors. Thus,
since invention-related activities are affectedby not only individual researchers’ efforts but
also contingency and other various elements,
employees engaged in such activities may have a
far higher uncertainty of the outcome of theirefforts than those engaged in other types ofoccupations such as marketing and automobile
assembly.(*5)
The second factor is the difficulty in evaluating
performance that qualifies for compensation. In
a large-scale survey by Marsden, et al. (2002)
regarding the implementation of the performancebased salary system for public employees in the
United Kingdom, it was verified that performancebased pay was generally effective for whitecollar employees but that it might rather
decrease incentives for them if they weredissatisfied with evaluation of their performance.
As a “reasonable remuneration,” employees
require compensation to be paid not only at thetime of filing of a patent application and the timeof patent registration but also based on the actual
performance of the patent, e.g. sales, profits, androyalty income arising form the patent. However,with the exception of certain industries including
the pharmaceutical industry, a single product(*3) Fumio Otake (2005) explains the reason why the court decision granting Mr. Shuji Nakamura 20 billion yen in
performance-based compensation is supported among researchers who generally do not desire performance-based
pay, by applying the principle under which people buy lottery tickets. People buy lottery tickets because they havethe tendency to overestimate the probability of success beyond an objective level, even though the probability is
actually very low. This also applies to performance-based pay: researchers overestimate the probability of successin making inventions, even though the probability is actually very low, and desire performance pay despite a low
likelihood of earning it. According to this theory, companies would be able to reduce salary costs and increase
profits by offering such a performance-based salary system.
(*4) Prentergust (2001) theoretically analyzed the fact that the performance-based pay system was implemented for
occupations with higher uncertainty, which runs contrary to contract theory, and found that performance-basedsalary was paid to cover achievements made by agents that often could not be sufficiently monitored due touncertainty.
(*5) The effectiveness of performance-based pay for employees engaged in particular occupations, such as marketing
and assembly operation, has been verified in many papers; for details, see Prentergust (1999).
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generally involves multiple patents, and it isdifficult to assess the degree of contribution ofeach patent. Where one product involves
hundreds or thousands of patents, such as seen in
the case of semiconductors and LCDs, it iseffectively impossible to assess the degree ofcontribution of each patent to sales or profits.
Such difficulty in patent evaluation is clearlyreflected in the fact that in Germany, despite theguidelines for compensation calculation, disputes
endlessly occur between inventors and companies.
It is also confirmed by a questionnaire survey
which showed many employees to be dissatisfied
with the evaluation of their inventions.
Compensation
systemsforemployeeinventions have other problems too, including
multi-task issues, a sense of inequality between
employees engaged in research fields wheremaking inventions is relatively easy and those infields where it is not, and delays in payment ofcompensation due to the time lag between when
the inventions are made and when they achieve
performance.

Ⅲ Past Research Surveys
The effect of performance-based remuneration
has not yet been sufficiently studied, except forthe case where Haftel and Martin (1993)
conducted a survey targeting 48 high-technology
companies in the State of Connecticut and foundthat both pecuniary compensation and nonpecuniary compensation (e.g. awards) wereeffective in increasing the number of patents.
However, they pointed out that payment of a large
amount of compensation over $50,000 was only
effective for small-sized companies including
venture companies, suggesting that many
researchers in venture companies preferpecuniary compensation. Lach and Schankerman(2004) analyzed whether the system to pay
university researchers compensation in proportion
to royalty income would increase a university’s
total royalty income. They found that an increaseby 1% of the royalty share for researchers would
increase royalty income by 4.5%. They also
found that this effect was produced by two
factors---increased incentives for university
researchers and the flow of researchers who
prefer pecuniary compensation into universities.
Savitsky (1991) conducted a questionnaire
survey targeting 203 US companies, and foundthat about 91% of all target companies provided afixed amount of compensation for the filing of apatent application, whereas companies providing

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compensation for remarkable inventions andthose providing compensation based on profits
only accounted for 15% and 7% respectively.
Savitsky pointed out that in the United States,
although the transfer of employees’ inventions
was effected by a contract between companies
and researchers, performance-based compensation
systems were adopted by only a limited numberof companies, and this very fact suggested that
performance-based compensation systems might
not be effective. Meier (1998) pointed out thatpayment of compensation at the time of transfer
of inventions as required under the German law
on employee inventions would increase costs
incurred by companies in obtaining patents andalso produce other adverse effects, such as
disputes between inventors and companies overpayment of compensation, prevention of theexchange of information among researchers, andresearchers’ tendency to prevent others frommaking inventions that would replace their own
invention. Nagaoka (2006) presented problems
with compensation systems, such as uncertainty
of inventions, evaluation risk and costs, andmulti-task issues, pointing out that researcher
evaluation systems should basically be diverse
and that limiting the scope of options by law was
inappropriate.
In an attempt to investigate the effect ofperformance-based
compensation
systems,
Harhoff and Hoisl (2004) and the Institute ofIntellectual Property (IIP) (2003) conductedquestionnaire surveys targeting inventors.
Harhoff and Hoisl targeted 3,346 inventors
whose inventions had been filed for patents atthe European Patent Office (EPO). In the survey,
60% of the respondents regarded the German law
on employee inventions as providing R&D
incentives, whereas 30% evaluated the law
negatively. Among the reasons for the negative
view, a “small amount of compensation” waschosen by the most respondents, at 33.6%, withan “opaque calculation method” chosen by 32%
and “delays in payment” by 15.3%, indicatingthat most respondents found problems with theamount of compensation. The IIP (2003) targeted
2,394 Japanese inventors in its questionnaire
survey. Among the possible R&D incentives,“growth of the company’s business,” “better
evaluation as a researcher,” and “compensation”
ranked first to third, suggesting that pecuniarycompensation is not the most effective means toincrease R&D work incentives for inventors. In
response to the question as to whether or notcompensation provides incentives, 60% of the● 196 ●

respondents answered positively whereas 25%
answered negatively. Among the reasons forthe negative view, the “small amount ofcompensation” ranked first, followed by “delays
in payment.” This also suggests, as the survey by
Harhoff and Hoisl (2004) indicates, that mostinventors are dissatisfied with the amount ofcompensation.

Ⅳ Formation of Hypotheses
In light of the problems with compensation
systems for employee inventions and the past
survey results described above, this researchstudy examines the hypotheses shown below. The
first hypothesis is as follows.
Hypothesis 1: Compensation systems based on
performance such as sales, profits, and royalty
income increase the number of patents but do
not have any significant effect on theacquisition of valuable patents
Performance-based compensation systems
may increase incentives for researchers. However,as mentioned above, the effect is limited becauseof the high uncertainty of inventions and highevaluation risk.
On the other hand, under compensation
systems based on filing/registration, compensation
is to be paid for inventions when they result in
the filing of patent applications or registration ofpatents, and therefore, such compensation
systems involve lower evaluation risk thanperformance-based compensation systems. From
this perspective, another hypothesis is formed:
Hypothesis 2: Compensation systems based on
filing/registration greatly contribute to increasing
the number of patents because of lower
evaluation risk than that for performance-based
compensation systems(*6)
However, under compensation systems
based on filing/registration, a fixed amount ofcompensation is paid for inventions when they
result in the filing of patent applications orregistration of patents, irrespective of the value ofthe patents. Therefore, such compensation systems
may not increase the number of patents that are
more valuable than being merely qualified forcompensation. This leads to another hypothesis:

Hypothesis 3: Compensation systems based on
domestic filing/registration do not increase thenumber of overseas patent applications oroverseas patents
This research study uses the number of US
patents as an indicator of performance.
Compensation systems based on domestic
filing/registration are not expected to increase
the number of patents that are so valuable as tobe filed or registered overseas.
In addition, the following hypotheses are also
examined:
Hypothesis 4: Compensation systems based on
royalty income are more effective in increasing
the number of patents because of low
evaluation risk
Hypothesis 5: If researchers are more consciousof uncertainty of inventions than evaluation
risk, then in the pharmaceutical industry,
performance- based compensation systems
increase incentives for researchers and lead tovaluable inventions
Compensation systems based on royalty
income involve low evaluation risk because eachpatent is evaluated through negotiation with thelicensee. However, the number of patents
licensed to third parties is smaller than thenumber of patents used for in-house exploitation,and such licensed patents are highly likely to beleft unused by licensees. Even in thepharmaceutical industry, although it is relatively
easier than in other industries to evaluate
individual patents because of strong linkage
between patents and products, making inventions
that can result in commercial products is anextremely difficult task. The last two hypotheses
have in common low evaluation risk comparedwith uncertainty of use or inventions. If thesehypotheses are successfully verified, it would
follow that researchers are more conscious ofevaluation risk than uncertainty of inventions.

Ⅴ Outline of the Questionnaire
Survey and the Status of
Implementation of Compensation
Systems for Employee Inventions
In this research study, a questionnaire
survey was conducted for the purpose ofinvestigating the status of implementation of(*6) See Supplementary note 1 for the impact uncertainty of invention and evaluation risk have on the effectiveness ofcompensation systems for employee inventions.

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compensation systems for employee inventions.
The survey targeted 836 manufacturing
companies that were listed on the first section of
the Tokyo Stock Exchange at the end of March
2005. The questionnaire sheet was sent on July
21 and the deadline for response was set atAugust 31. Among the targeted companies, 360
companies responded to the questionnaire(response rate: 43.1%). A final analysis was madewith respect to 347 companies, with twocompanies excluded that had not obtained any
patent in the past 15 years and 11 companies that
refused to answer some major questions.
The number of companies that implementedcompensation systems based on domestic filings
was 248 (82%) in 1990 and 323 (93%) in 2005
respectively, indicating that a significant numberof companies implemented compensation systems
based on domestic filings. This result
corresponds with the result obtained from thequestionnaire survey conducted by the IIP(2003).(*7) The number of companies that
implemented compensation systems based on
domestic registration was slightly lower than thenumber of those implementing compensation
systems based on domestic filings, but gradually
increased from 254 (73%) in 1990 to 288 (83%) in
2005.
The number of companies that implementedcompensation systems based on overseas
filing/registration increased during the period
from 1990 to 2005, from 45 (13%) to 75 (22%) for
filing and from 56 (16%) to 91 (26%) for
registration, whereas the percentage ofcompanies implementing overseas compensation
systems was smaller than that of companies
implementing domestic compensation systems.
Among the finally targeted companies, 310
companies owned US patents, and at least 93% ofthem obtained more than one US patent during
the period from 1988 to 2002 and were likely tobe actually operating business overseas.
Nevertheless, there are only a limited number ofcompanies that implemented compensation
systems for overseas filing/registration. This may
be because a generally accepted view has not yet
emerged regarding whether a “reasonable
remuneration” under Section 35 of the Patent
Law shall also be required for the transfer offoreign patents. If Section 35 also covered
overseas performance, more companies would
introduce overseas compensation systems in the

future.
In this questionnaire, five options were
offered in respect of the amount of compensation
for filing/registration: “less than 5,000 yen,”“5,000-10,000 yen,”“10,000-30,000 yen,”“30,000-100,000yen,” and “100,000 yen or more.”
In 1990, most companies offered a very small
amount of compensation for filing, 39% offering
less than 5,000 yen and 85% offering less than
10,000 yen, whereas in 2005, the proportion of
those offering less than 5,000 yen and less than
10,000 yen declined to 14% and 57% respectively,
suggesting that many companies increased theamount of compensation for filing. This trend isalso seen in respect of the amount ofcompensation for registration: the proportion ofcompanies offering less than 10,000 yen declinedby two-thirds, from 30% in 1990 to 11% in 2005.
The number of companies offering 100,000 yen or
more as compensation increased from two in 1990
to 11 in 2005.
The next topic is the trend in the number ofcompanies that implemented performancebased compensation systems, under which
compensation is paid when inventions actuallyachieve results, e.g. patents contribute to thecompany’s sales and profits or produce royalty
income. The number of companies that
implemented performance-based compensation
systems increased from only 180 (52%) in 1990 to
274 (71%) in 2005. However, the number was far
smaller than the number of companies that
implemented compensation systems based on
domestic filing/registration. From 1990 to 2005,
the number of companies that implemented
performance-based
compensation
increasedslowly and the rate of increase also increasedslightly since the second half of the 1990s. This
trend seems to be in line with the increase in thenumber of lawsuits filed by employees since theOlympus case in 1995. In the first half of the
1990s, the number of companies that introduced
performance-based compensation systems peakedin 1992. This trend seems to correspond to thefact that the district court made a decision on theemployee’s lawsuit against Kaneshin in that year,
and lawsuits had also been filed by employees
against Zojirushi and Gosen for a “reasonable
remuneration” in the previous year.
Looking at the trend in the number ofcompanies that implemented performance-based
compensation systems by type of performance,(*7) Among the respondents to the questionnaire survey conducted by the IIP in 2003, more than 90% of large
companies implemented compensation systems based on domestic filings.

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throughout the survey period, the number ofcompanies that implemented compensation
systems based on contribution to the company’ssales and profits or contribution to revenues fromthe company’s products was the largest (167 in
1990, 283 in 2005). The number of companies that
implemented compensation systems based on
royalty income (including royalty income undercross-licensing) was 133 in 1990, accounting for
80% of the companies that implementedcompensation systems based on sales/profits.
That number increased to 246 in 2005, accounting
for 87%, indicating that many companies
introduced compensation systems based on
licensing.(*8)
In this questionnaire, six options were
offered in respect of the maximum amount of
performance-based compensation: “less than
100,000 yen,” “100,000-1 million yen,” “1-10
million yen,” “10-100 million yen,” “10 million
yen or more,” “no upper limit.” The largest
amount of compensation offered by each company
for any of the three types of performance wasregarded as the company’s maximum amount ofcompensation. Until 2000, the companies thatoffered less than 10 million yen accounted for
60%, and the remaining 40% only offered 1
million or less. However, in 2005 when theamendment was made to the provisions on
employee inventions under the Patent Law, thenumber of companies that abolished the upper
limit rapidly increased. This may be because thelegal amendment increased the possibility thatsetting an upper limit to the amount ofcompensation would be regarded as a violation of
the requirement for “reasonable regulations.”
There
are
three
ways
of
payingcompensation based on performance: paying astandard amount of compensation upon in-house
exploitation of patents, irrespective ofperformance; paying a fixed amount ofcompensation according to the degree ofcontribution of the performance; and paying anamount of compensation in proportion to theperformance by using the degree of contribution
as a coefficient. With respect to compensation forcontribution to the company’s sales and profits,
the companies that offered a fixed amount ofcompensationaccordingtoperformanceaccounted for 22% in 1990 and 25% in 1995,
whereas the companies that offered an amount ofcompensation in proportion to performanceaccounted for 19% in 1990 and 20% in 1995.

During the 1990s, for in-house exploitation, thenumber of companies applying fixed-rate payment
had been larger than the number of companies
applying proportional payment. On the other hand,with respect to compensation upon receiving
royalty income, the companies that offered afixed amount of compensation according toperformance accounted for 10% in 1990 and 12%
in 1995, whereas the companies that offered anamount of compensation in proportion to
performance accounted for 24% in 1990 and 25%
in 1995. The number of companies applying
proportional payment was significantly larger
than the number of companies applying fixed-rate
payment. The fact that fixed-rate payment isapplied more frequently for in-house exploitation
than for licensing may suggest the difficulty inevaluating the degree of contribution in the caseof in-house exploitation

Ⅵ Estimation Methods
This research study applied the knowledge
production function in order to verify the effect of
the implementation of compensation systems.
The knowledge production function, which was
advocated by Griliches and Schankerman (1984),shows the rate of contribution of R&D
investment to the increase in knowledge, andgenerally uses the number of patents as a proxyvariable for knowledge. This research study aims
to examine the impact of compensation systems
on the increase in knowledge by inserting
variables relating to compensation systems in theknowledge production function.

Ⅶ Estimation ResultsCompensation systems based on domestic
filing/registration do not contribute to increasing
the number of US patents whereas compensation
systems based on overseas filing/registration
increase the number of US patents. This suggests
the possibility that compensation systems basedon filing/registration may increase the number ofpatents that are valuable enough to be qualified
for compensation but do not lead to theacquisitionof
more
valuablepatents.
Compensation systems based on performancesuch as sales and royalty income are effective inincreasing the number of US patents; however, as
in the case of compensation systems based on
filing/registration, they do not contribute to(*8) For the implementation status by industry, see Appendix 4.
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increasing the number of patents more valuable
than those merely qualifying for compensation.
These results suggest that compensation systems
are effective in increasing the number of patents
rather than increasing the quality of patents.
If focus is placed on the effect of increasing
the number of patents, compensation systems
based on filing/registration are more effective
than performance-based compensation systems.
However, compensation systems based on royalty
income and performance-based compensation
systems in the pharmaceutical industry involve
low evaluation risk, and therefore they are aseffective as or more effective than compensation
systems based on filing/registration. Thissuggests the possibility that performance-based
compensation systems are more effective where
evaluation risk is low. This corresponds with thefact that most inventors who are dissatisfied withcompensation systems complain about theamount of compensation or the calculation
standards.
Performance-based compensation systems
are less effective in companies that implement
such systems only for the passive reason ofcomplying with Section 35 of the Patent Law.
Award systems are also effective in increasing thenumber of patents.
Consequently, the following implications canbe obtained from this research study.
The research study successfully verified thatcompensation systems implemented by Japanesecompanies are effective to a certain extent inincreasing their motivation toward innovations.
This corresponds with the view shared among
companies and inventors that compensation
systems lead to increasing researchers’ motivation
to make inventions. However, it is also suggested
that the effect of compensation systems is limited,
and they are more effective in increasing thenumber of patents rather than increasing thequality of patents. Compensation systems may
not function sufficiently to increase incentives
for researchers in such companies that implement
the systems only for the passive reason ofcomplying with Section 35 of the Patent Law, andthis analysis result suggests that it isinappropriate to place excessive expectations in
the effect of compensation systems forresearchers.
These results suggest the possibility that the
recent rise in the amount of compensation may
not function effectively to increase incentives forresearchers.
This research study was also successful in

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verification of contract theory. Past empiricalanalysesregardingtheeffectivenessof
performance-based pay systems only targeted alimited range of occupations, such as CEOs andmarketing staff, workers on production lines, andprofessional athletes (Prentergust, 1999). In thisrespect, this research study that attempted toinvestigate the effect of compensation systems
for researchers can be regarded as an empiricalanalysis on performance pay systems that has
never previously been made. Furthermore, thestudy result that performance-based pay systems
cannot function effectively where evaluation risk
is high empirically supports contract theory.

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