We explore how firms govern exchanges that require innovation. Transaction cost economics focuses on the role of overcoming bounded rationality and mitigating opportunism when designing governance mechanisms such as contracts. While TCE is very powerful in illustrating how to prevent negative events during transactions, it is less able to explain how to design contracts that can help foster a strong positive environment that facilitates innovation. By incorporating insights from social psychology to complement TCE, we argue that firms can improve their chances to generate innovative outcomes in inter-firm transactions. Contracts can do more than simply eliminate negative outcomes and can help set a frame that can encourage a positive outcome. A major challenge occurs when a transaction involves a need for innovation and a significant exchange hazard. While innovation often leads firms to use more detailed task descriptions, because these can be framed in ways that don’t necessarily imply distrust or negative expectations, the presence of exchange hazards makes this framing challenge more difficult and leads firms to rely less on detailed task descriptions. We also explore how firms structure the payment mechanism in the contract to help foster the flexible, creative environment that is most suitable for innovation. We examine and find support for these effects in a sample of contracts from the information technology services industry.