INSEAD Working Paper 2011/45/TOM/OB
In this paper, we analyze the optimal contractual arrangements in a bilateral R&D partnership between a pharmaceutical and a biotech firm. The biotech firm conducts early-stage research activities, while the pharmaceutical firm performs late-stage development activities, including production, distribution and mar- keting. We model the incentive alignment problems inherent in such partnerships using a principal-agent framework, and consider the cases where either the biotech firm or the pharmaceutical firm is the principal. We formulate the problem as a sequential investment game between the parties with double moral hazard where the investments made by both parties are observable, but not verifiable, and we also model the risk preferences of the biotech firm. When both firms are risk-neutral, we find that the first-best solution can be attained, and characterize the optimal contracts based on renegotiation, late-stage contracting, and options mechanisms that result in the first-best outcome. If the biotech firm is risk-averse, we show that the timing of the contract affects the attainment of the first-best solution, and identify optimal contracts that result in the first-best solution. Our research offers a systematic framework for choosing contracts to overcome agency problems that are commonly encountered in R&D partnerships in the healthcare industry.