Corporate governance mechanisms can be a means to keep managers in line and ensure they work towards the interests of the firm's owners. The problem is that, there is no "one-size-fits-all" solution. Some mechanisms work better in certain firms than others.

In highly innovative firms that depend on firm-specific knowledge assets to create economic value, for instance, managers need flexibility to act, since their overseers, such as the board of directors and shareholders, possess less reliable information than themselves in such situations. The overseers, however, still want to make sure that managers act in the firm's interests. So the trick is to find the right type of corporate governance mechanism to achieve that goal without unduly restricting managers' discretion to act.

In a study of 215 knowledge-intensive firms in the U.S., Jinyu He and Heli C. Wang look at two common mechanisms - incentives and monitoring - and find that incentives offer more economic performance advantages to innovative firms but monitoring tends to harm such firms.

"The challenge is to grant managers sufficient discretion to make strategic decisions, while limiting their motivation to pursue self-interested goals at the owners' expense. Normally that means monitoring and/or incentives. However, in innovative firms, monitoring is inevitably based on limited information, poor assessment of managerial behaviour or myopic financial criteria, and excessive monitoring may inhibit managers from exercising the discretion necessary," the authors say.

Incentives, on the other hand, offer that discretion and also tie top managers' interests more tightly to those of the firm. Equity ownership and compensation that is contingent on firm performance are two typical incentive mechanisms for managers.

"Top managers in innovative firms are often required to make significant firm-specific human capital investments that have limited value in the general labour market. In such situations, equity ownership rights represent residual rights of control which can give managers some bargaining power and motivate them to develop such investments in a most productive way."

That is not to say incentives are perfect. Stock options, for instance, may lead to excessive risk taking, or managers may be tempted to manipulate short-term performance measures and firm stock price for their own personal gain. But the authors argue that for innovative firms, the benefits of using incentives still outweigh its downsides.

So, while innovative knowledge assets generally have a positive impact on a firm's economic performance, that link will be stronger in firms that use incentive-based corporate governance mechanisms, rather than monitoring. Additionally, the authors show that the presence of CEO "duality", in which the CEO also chairs the board of directors thus reducing monitoring, can have a positive effect because it reduces information asymmetry between the board and the managers.