A comparison of milestone-based and buyout options contracts for coordinating R&D partnerships

• Main Authors: BHATTACHARYA, Shantanu, GABA, Vibha, HASIJA, Sameer
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2015
• Subjects: R&D partnerships; options contracts; double-sided moral hazard; holdup; risk preference; Contracts; Operations and Supply Chain Management
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/5104; https://ink.library.smu.edu.sg/context/lkcsb_research/article/6103/viewcontent/mnsc_2E2013_2E1874__1_.pdf
• Institution: Singapore Management University

We analyze optimal contractual arrangements in a bilateral research and development (R&D) partnership between a risk-averse provider that conducts early-stage research followed by a regulatory verification stage and a risk-neutral client that performs late-stage development activities, including production, distribution, and marketing. The problem is formulated as a sequential investment game with the client as the principal, where the investments are observable but not verifiable. The model captures the inherent incentive alignment problems of double-sided moral hazard, risk aversion, and holdup. We compare the efficacy of milestone-based options contracts and buyout options contracts from the client's perspective and identify conditions under which they attain the first-best outcome for the client. We find that milestone-based options contracts always attain the first-best outcome for the client when the provider has some bargaining power in renegotiation and identify their applicability to different R&D partnerships.