Step by step. The benefits of stage-based R&D licensing contracts

• Published in: European journal of operational research 2013-02, Vol.224 (3), p.572-582
• Main Authors: Crama, Pascale, De Reyck, Bert, Degraeve, Zeger
• Format: Article
• Language: English
• Subjects: Adverse selection; Asymmetric information; Contract design; Industries; Innovation; Licenses; Licensing; Operations research; Optimization techniques; Pharmaceutical; R&D; Research & development; Research and development; Royalties; Studies
• ISSN: 0377-2217; 1872-6860
• DOI: 10.1016/j.ejor.2012.09.014

► R&D licensing contracts can be optimally structured to tackle information asymmetry. ► Contracts with phased payments can be used to discriminate between different licensees. ► Timing of the licensing decision can have a significant influence on the project value. ► Risk-averse inventors should use multiple milestones. We examine how a licensor can optimally design licensing contracts for multi-phase R&D projects when he does not know the licensee’s project valuation, leading to adverse selection, and cannot enforce the licensee’s effort level, resulting in moral hazard. We focus on the effect of the phased nature typical of such projects, and compare single-phase and multi-phase contracts. We determine the optimal values for the upfront payment, milestone payments and royalties, and the optimal timing for outlicensing. Including multiple milestones and accompanying payments can be an effective way of discriminating between licensees holding different valuations, without having to manipulate the royalty rate, which induces licensees to invest less, resulting in lower project values and socially suboptimal solutions. Interestingly, we also find that multiple milestone payments are beneficial even when the licensor is risk-averse, contrary to standard contract theory results, which recommend that only an upfront payment should be used. In terms of licensing timing, we show that the optimal time depends on the licensor’s risk aversion, the characteristics of the licensee and the project value.