Opt-Out Options in New Product Co-DevelopmentPartnerships
London Business School, Regent’s Park, London NW1 4SA, UK, email@example.com
Judge Business School, University of Cambridge, Cambridge CB2 1AG, UK, firstname.lastname@example.org
We study three contractual arrangements - co-development, licensing and co-development with opt-outoptions - for the joint development of new products between a small and ﬁnancially constrained innovatorﬁrm and a large technology company, as in the case of a biotech innovator and a major pharma company. Weformulate our arguments in the context of a two-stage model, characterized by technical risk and stochasti-cally changing cost and revenue projections. The model captures the main disadvantages of the traditionalco-development and licensing arrangements: In co-development the small ﬁrm runs a risk of running out of capital as future costs rise, whilst licensing for milestone and royalty payments, which eliminates the latterrisk, introduces ineﬃciency as proﬁtable projects might be abandoned. Counter to intuition we show thatthe biotech’s payoﬀ in a licensing contract is not monotonically increasing in the milestone/royalty terms.We also show that an option’s clause in a co-development contract that gives the small ﬁrm the right butnot the obligation to opt out of co-development and into a pre-agreed licensing arrangement avoids theproblems associated with fully committed co-development and immediate licensing: The probability that thesmall ﬁrms runs out of capital is greatly reduced or completely eliminated and proﬁtable projects are neverabandoned.
: New product development, pharmaceutical R&D, contracts, real options
: Revised - June 26, 2012
In many industries, most notably in the high-tech sector, R&D alliances and partnerships arevaluable complements to the wholly owned industrial R&D labs (Hagedoorn 2002, Aggarwal andHsu 2009). The pharmaceutical industry is a case in point. The growth in biomedical knowledge haslargely occurred in relatively small biotechnology companies (Danzon et al. 2005). These ﬁrms raiseﬁnance on the back of promising scientiﬁc and technological developments and the hope that thesecan be turned into products of value. As they lack the vast resources necessary to develop a drugto market they seek to partner with major pharma corporations in order to access further fundingand capabilities, such as full-scale clinical development, marketing and sales. A second example isthe impact of nanotechnology on materials and electronics. Much of these advances come directly