We study three contractual arrangements – co-development, licensing, and co-development with opt-out options – for the joint development of new products between a small and financially constrained innovator firm and a large technology company, as in the case of a biotech innovator and a major pharma company. We formulate our arguments in the context of a two-stage model, characterized by technical risk and stochastically changing cost and revenue projections. The model captures the main disadvantages of traditional co-development and licensing arrangements: In co-development the small firm runs a risk of running out of capital as future costs rise, while licensing for milestone and royalty (M&R) payments, which eliminates the latter risk, introduces inefficiency as profitable projects might be abandoned. Counter to intuition we show that the biotech’s payoff in a licensing contract is not monotonically increasing in the M&R terms. We also show that an option clause in a co-development contract that gives the small firm the right but not the obligation to opt out of co-development and into a pre-agreed licensing arrangement avoids the problems associated with fully committed co-development or licensing: the probability that the small firm will run out of capital is greatly reduced or completely eliminated and profitable projects are never abandoned. Key words: New product development, pharmaceutical R&D, contracts, real options 1
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