The Impact of Royalty Contract Revision in a Multi-Stage Strategic R&D Alliance

This paper investigates the impact of royalty revision on incentives and profits in a two-stage (R&D stage and marketing stage) alliance with a marketer and an innovator. The marketer offers royalty contracts to the innovator. We find the potential for royalty revision leads to more severe distortions in the optimal initial royalty contracts offered by the marketer. We show if the innovator plays a significant role in the marketing stage, the marketer should offer a low royalty rate initially and then revise the royalty rate up later. Otherwise, she should do the opposite. We identify two major effects of royalty revision. First, royalty revision provides the marketer with a flexibility to dynamically adjust royalty rates across the two stages of the alliance to better align the innovator’s incentives. This incentive realigning effect improves the marketer’s profit. Second, royalty revision makes it harder for the marketer to obtain private information from the innovator because the innovator worries the marketer will take advantage of the information to revise the initial contract to a more favorable one to herself later. This information revealing effect hurts the marketer’s profit. We characterize in what kind of alliances marketers would benefit the most from royalty revision so that managers should clearly establish the expectation for royalty revision, and in what kind of alliances marketers would not benefit from royalty revision so that managers should commit not to revise the initial royalty contract. With royalty contracts that are contingent on the R&D outcome of the R&D stage, we find that contingent contract structure could be either substitutable (by fully capturing the incentive re-aligning effect) or complementary (by weakening the information revealing effect) to royalty revision depending on whether the innovator plays a significant role of the marketing stage. Managers may need to use contingent contract (if possible) either to replace or with royalty revision accordingly to improve profits