INSEAD Working Paper 2011/98/TOM/OB revised version of 2011/45/TOM/OB
We analyze optimal contractual arrangements in a bilateral R&D partnership between a risk-neutral pharmaceutical firm and a risk-averse biotech firm. The biotech firm conducts early-stage research, followed by the regulatory verification stage, while the pharmaceutical firm performs late-stage development activities, including production, distribution, and marketing. We model the inherent incentive alignment problems in such partnerships using a principal-agent framework, with either the pharmaceutical or the biotech firm as the principal. The problem is formulated as a sequential investment game with double-sided moral hazard where the investments are observable but not verifiable. When the pharmaceutical firm is the principal, the first-best solution can be attained only if the biotech firm's degree of risk aversion is below a threshold. We characterize options-based contracts that result in the first-best outcome, and find that milestone payments (conditional on regulatory approval) are a critical component of such contracts. If the biotech firm is the principal, a wider range of contracts obtain the first-best solution. Finally, we show that the timing of the contract affects the attainment of the first-best solution. Our research offers a systematic framework for choosing contracts to overcome agency problems commonly encountered in the pharmaceutical R&D supply chain.