Milestone Payments or Royalties? Contract Design for R&D Licensing

We study how innovators can optimally design licensing contracts when there is incomplete information on the licensee's valuation of the innovation, and limited control over the licensee's development efforts. A licensing contract typically contains an up–front payment, milestone payments at successful completion of a project phase, and royalties on sales. We use principal–agent models to formulate the licensor's contracting problem, and we find that under adverse selection, the optimal contract structure changes with the licensee's valuation of the innovation. As the licensee's valuation increases, the licensor's optimal level of involvement in the development—directly or through royalties—should decrease. Only a risk–averse licensor should include both up–front and milestone payments. Moral hazard alone is not detrimental to the licensor's value, but may create an additional value loss when combined with adverse selection. Our results inform managerial practice about the advantages and disadvantages of the different terms included in licensing contracts and recommend the optimal composition of the contract.