Working Paper
The authors analyze optimal contractual arrangements in a bilateral R and 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.
The authors 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.
The authors find that attaining the first-best outcome is easier for the client when
the provider has some bargaining power in renegotiation, and milestone-based options contracts attain the
first-best solution in a wider range of cases than buyout options contracts.
Faculty
Professor of Entrepreneurship
Professor of Technology and Operations Management
