Contractibility and the Design of Research Agreements

The pervasiveness of research agreements between pharmaceutical and biotechnology companies is puzzling, since it is hard to contract on the exact nature of the research activities. A major concern of financing companies is that the R&D firms use their funding to subsidize other projects or substitute one project for another. We develop a model based on the property-rights theory of the firm that allows for researchers in the R&D firms to pursue multiple tasks. When research activities are non-contractible, we show that it is optimal for the financing company to obtain the option right to terminate the research agreement while maintaining the property rights to the terminated project. This right will induce the biotechnology firm researchers not to deviate from the proposed research activities. The contract prevents opportunistic exercise of this termination right by conditioning payments on the termination of the agreement. We test the model empirically using a new data set on 584 biotechnology research agreements. We find that the assignment of termination and ownership rights to the financing firm occurs in contractually difficult environments in which the parties cannot specify the lead product candidate. We employ further empirical tests to distinguish the property-rights explanation from alternative stories, based on uncertainty and asymmetric information about the project quality or research abilities. We would like to thank Susan Athey, Oliver Hart, Thomas Hellmann, Rebecca Henderson, Jeff Zwiebel as well as workshop participants at MIT, the NBER Organizational Economics Meeting, Simon Fraser University, and Stanford University for helpful comments. We also benefited from conversations with a number of practitioners, especially Prem Das and Michael Lytton. Charmaine Lee, Burak Guner, Felix Momsen, and Chenling Zhang provided excellent research assistance. Harvard Business School’s Division of Research provided financial support. All errors are our own.