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

Lee Kong Chian School of Business, Singapore Management University, 178899 Singapore
Department of Management Science and Innovation, University College London, London WC1E 6BT, United Kingdom, and Department of Management Science and Operations, London Business School, Regent's Park, London NW1 4SA, United Kingdom
Department of Management Science and Operations, London Business School, Regent's Park, London NW1 4SA, United Kingdom
pcrama{at}smu.edu.sg
bdereyck{at}ucl.ac.uk
bdereyck{at}london.edu
zdegraeve{at}london.edu

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.

Subject classifications: health care; pharmaceutical; research and development; innovation; principal-agent modeling; adverse selection; moral hazard; contract design.
History: Received September 2006; revision received April 2008; accepted May 2008.