The Role of Milestone-based Contracts for Coordinating R&D Partnerships

We 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. We 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. We 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