Opt-Out Options in New Product Co-development Partnerships

We study three contractual arrangements–co‐development, licensing, and co‐development with opt‐out options–for the joint development of new products between a small and financially constrained innovator firm and a large technology company, as in the case of a biotech innovator and a major pharma company. We formulate our arguments in the context of a two‐stage model, characterized by technical risk and stochastically changing cost and revenue projections. The model captures the main disadvantages of traditional co‐development and licensing arrangements: in co‐development the small firm runs a risk of running out of capital as future costs rise, while licensing for milestone and royalty (M&R) payments, which eliminates the latter risk, introduces inefficiency, as profitable projects might be abandoned. Counter to intuition we show that the biotech's payoff in a licensing contract is not monotonically increasing in the M&R terms. We also show that an option clause in a co‐development contract that gives the small firm the right but not the obligation to opt out of co‐development and into a pre‐agreed licensing arrangement avoids the problems associated with fully committed co‐development or licensing: the probability that the small firm will run out of capital is greatly reduced or completely eliminated and profitable projects are never abandoned.