Title

Milestone Payments or Royalties? Contract Design for R&D Licensing

Publication Type

Journal Article

Version

Preprint

Publication Date

11-2008

Abstract

We study how innovators can optimally design licensing contracts when there is incomplete information on the licensee's valuation of the innovation, and limited control over the licensee's development efforts. A licensing contract typically contains an up-front payment, milestone payments at successful completion of a project phase, and royalties on sales. We use principal-agent models to formulate the licensor's contracting problem, and we find that under adverse selection, the optimal contract structure changes with the licensee's valuation of the innovation. As the licensee's valuation increases, the licensor's optimal level of involvement in the development-directly or through royalties-should decrease. Only a risk-averse licensor should include both up-front and milestone payments. Moral hazard alone is not detrimental to the licensor's value, but may create an additional value loss when combined with adverse selection. Our results inform managerial practice about the advantages and disadvantages of the different terms included in licensing contracts and recommend the optimal composition of the contract. [PUBLICATION ABSTRACT]

Keywords

health care, pharmaceutical, research and development, innovation, principal-agent modeling, adverse selection, moral hazard, contract design

Discipline

Operations and Supply Chain Management | Technology and Innovation

Research Areas

Operations Management

Publication

Operations Research

Volume

56

Issue

6

First Page

1539

Last Page

1552

ISSN

0030-364X

Identifier

10.1287/opre.1080.0589

Publisher

INFORMS