Innovation is the key and fundamental forces for firms to survive and grow in a competitive environment. The paper aims to examine the correlation between Transformational Leadership (TL) and employees’ psychological sources and how they affect an organization’s Innovation Capability (IC). Structural Equations Modeling (SEM) is utilized to elaborate the relationship among the proposal factors using survey data gathered from 315 participants of 65 medium and small-sized firms in Vientiane, Laos. The findings show that employees’ psychological sources, namely optimism and self-efficacy, act as mediating roles in the effects of TL on IC. The findings revealed that TL’s Idealized Influence (TII) brings employees greater optimism, while individualized consideration creates a stronger self efficacy among employees. In addition, it highlighted the extreme importance of self-efficacy in stimulating IC compared with optimism’s effect. From a practical view, the paper highlights the importance and need to apply TL style in organization management to develop employees’ positive psychological capital and improve IC actively. The paper’s findings also bring deeper understanding and theoretical initiatives that can be applied to clarify the correlation among TL, forms of employees’ psychological capital, and IC.

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