A Comparison of Milestone-Based and Buyout Options Contracts for Coordinating R&D Partnerships

Shantanu Bhattacharya (), Vibha Gaba () and Sameer Hasija ()
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Shantanu Bhattacharya: INSEAD, Singapore 138676
Vibha Gaba: INSEAD, Singapore 138676
Sameer Hasija: INSEAD, Singapore 138676

Management Science, 2015, vol. 61, issue 5, 963-978

Abstract: 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. This paper was accepted by Yossi Aviv, operations management.

Keywords: R&D partnerships; options contracts; double-sided moral hazard; holdup; risk preference (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (13)

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