Licensing interim R&D knowledge

1. Licensing interim R&D knowledge Yossi Spiegel Tel Aviv University

2. Background • Many licensing agreements are reached in early stages of the R&D process • A 1/3 of all licensing deals between the top 12 pharmaceutical companies and biotech firms in 1991-2002 took place during preclinical testing (Kalmas, Pinkus, and Sachs, 2002) • Over 60% of all licensing deals between the top 20 pharmaceutical companies and biotech firms in 1997-2002 took place at the discovery and lead molecule phases (Howard, 2004) • About 50% of all biotechnology licensing agreements in Lim and Veugelers (2003) were made at the preclinical testing stage • The success rate for drugs at the preclinical testing stage is low (about 20% - see DeMasi, 2001) Licensing interim R&D knowledge

3. The main idea • Consider a winner-takes-all R&D contest for developing a new commercial technology (e.g., new drug, new cost effective production process) • Question:Should the leader in the contest, before it is decided, hold on to its lead or should it license/sell its superior knowledge to lagging firms? • Answer:If the leader can choose between licensing and selling the answer is YES. • If it can either license or sell (but cannot select between these two options) the answer is IT DEPENDS. • The problem differs from traditional patent licensing because what is licensed is only a chance to invent, not a sure thing (due to Bertrand competition, complete technologies will never be licensed) Licensing interim R&D knowledge

4. Main effects of licensing • Value creation: Raises the prob. that the licensee will succeed when the licensor fails • Value destruction: Raises the prob. that the licensee will succeed when the licensor succeeds • Rent extraction: The licensor can play the licensees off against one another since a non-licensee faces a lower prob. of being the sole developer of the new technology • The rent extraction effect is similar to the blackmail effect in Anton and Yao (AER, 1994; RES, 2002) and to the effect of licensing in Katz and Shapiro (QJE, 1986) Licensing interim R&D knowledge

5. Related literature • Kamien (Handbook of IO, 1992) - how should an outsider license a patent? • Gallini (AER, 1984) - An insider licenses knowledge to deter entry • Rockett (Rand, 1990) - An insider licenses to invite a weak rival • Bhattacharya, Glazer, Sappington (JET, 1992) - optimal design of RJV, including cross licensing of interim knowledge • d’Aspremont, Bhattacharya, Gerard-Varet (RES, 2000) – bargaining over licensing of interim knowledge under asym. info. • Bhattacharya and Gurive (JEEA, 2006) - comparison between patent-based licensing (exclusivity is feasible) and trade-secret-based licensing (exclusivity is not feasible) Licensing interim R&D knowledge

6. The model • 3 firms engage in an R&D contest, followed by Bertrand competition • The profit from being the sole developer of the new technology is 1; otherwise the profit is 0 • Knowledge: l1 > l2 ≥ l3 • Knowledge is Blackwell ordered • The expected profits absent licensing: Licensing interim R&D knowledge

7. Exclusive licenses • Firm 1 makes take-it-or-leave-it offers to firms 2 and 3 at fees, T2 and T3, and sets a tie-breaking rule in case both firms accept • Exclusive license to firm 2 (the case of firm 3 is analogous): Licensing interim R&D knowledge

8. Nonexclusive licenses • The expected payoffs: Licensing interim R&D knowledge

9. Lemma 1 • If firm 1 wishes to issue an exclusive license to firm j = 2,3, then it will set T2 and T3 such that so (accept, accept) is a NE and set a tie-breaking rule that says that firm j gets an exclusive license if both firms accept • If firm 1 wishes to issue nonexclusive licenses to both firms 2 and 3, then it will set T2 and T3 such that so (accept, accept) is a NE and set a tie-breaking rule that says that both firms get licenses if both accept • Interestingly, T2* >(<) T3* when l1 < (>) 1/2: firm 2 faces a weaker non-licensee so it values a license more, but it also cares less about being left behind Licensing interim R&D knowledge

10. Proposition 1 – the equil. • l1 is large: a license is not worth much to firms 2 and 3 but entails a large loss of technological lead from firm 1’s perspective • l1 is intermediate: firm 3 is willing to pay more (T3>T2), but licensing to firm 2 entails a smaller loss of technological lead (firm 2 has a “good” chance anyway) • l1 is small: licensing entails a small loss of technological lead (firm 1 is “far away” anyway) and allows firm 1 to play firms 2 and 3 off against one another (a license not only provides knowledge but also ensures that the firm is not left behind) Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/2 l*1 1 l1 Licensing interim R&D knowledge

11. Partial transfer of knowledge • What happens when firm 1 can control how knowledge it transfers? • Let D2 ≤ l1 - l2 and D3 ≤ l1 - l3 • Again, firm 1 makes take-it-or-leave-it offers such that rejection implies that firm 1 will transfer its entire knowledge to the rival firm. The offers are complemented by appropriate tie-breaking rule: Licensing interim R&D knowledge

12. Partial transfer of knowledge – the equil. Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/2 l*1 1 l1 Nonexclusive licenses Exclusive license to firm 2 “vacuous” licenses to firms 2 and 3 Licensing interim R&D knowledge

13. Transfer of knowledge between firms 2 and 3 • Firm 1 sets T2 and T3 such that p2 = l2(1-l1)2 and p3 = l3(1-l1)2 – the rival obtains an exclusive license • p2 + p3 = (l2+l3)(1-l1)2 - firms 2 and 3 benefit from transferring firm 2's knowledge to firm 3 and improve their bargaining positions vis-a-vis firm 1 • The agreement does not affect firm 1's choice between exclusive and nonexclusive licenses since this choice depends only on whether l1 is above or below 1/3 • Since l1* with λ₃, the agreement narrows the range of l1 for which firm 1 issues an exclusive license to firm 2 Licensing interim R&D knowledge

14. Firm 1's knowledge is worth more to firms 2 and 3 • In many cases, relatively small firms license out their interim R&D knowledge to large corporations (e.g., software industry or biotechnology) • Suppose that when firm 1's knowledge is l1, its prob. of developing the new technology is fl1, f∈[0,1] f 1/3 l*1 1 Licenses to firms 2 and 3 Exclusive license to firm 2 No licenses l1 1/2 1 Licensing interim R&D knowledge

15. Correlation • Suppose that after licensing, the success prob. of firm 1 and its licensee(s) become positively correlated: with prob. r, they are perfectly correlated and with prob. 1-r they are completely independent • The expected payoffs under an exclusive license to firm 2: • The expected payoffs under nonexclusive licenses to firms 2 and 3: Licensing interim R&D knowledge

16. Correlation – the equil. • When r is not too large, the qualitative results of Prop. 1 remain valid: • Nonexclusive licenses to firms 2 and 3 when l1* is small • Exclusive license to firm 2 when l1* is intermediate • No licenses when l1* is large • When r is relatively large, things change: • Firm 1 will never issue nonexclusive licenses to both firms 2 and 3 whenever • Firm 1 will issue an exclusive license to firm 3 whenever l1 < 1/3 and Licensing interim R&D knowledge

17. Bans on exclusive licenses • In some cases, U.S. firms were not allowed to issue exclusive licenses - in two separate consent decrees signed in 1956, AT&T and IBM were required to license their patents on a nonexclusive, world-wide basis to any applicant at a reasonable royalty • Bans on exclusive license may backfire! Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 l**1 l*1 1 l1 Nonexclusive licenses No licenses Licensing interim R&D knowledge

18. Acquisition of knowledge • Selling differs from licensing because after firm 1 sells its knowledge, it exits the R&D contest (e.g., firm j = 2,3 acquires firm 1 or acquires the relevant R&D lab or division of firm 1) • The expected payoffs under exclusive sale of knowledge to firm 2: • The expected payoffs under nonexclusive sale of knowledge to firms 2 and 3: Licensing interim R&D knowledge

19. Acquisition of knowledge – the equil. Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/(2-l3) 1/2 l*1 1 l1 Nonexclusive sale to firms 2 and 3 if (l1-l2-l3)(1-2l1) > l1l2l3 or no sale otherwise No sale Exclusive sale to firm 2 Licensing interim R&D knowledge

20. Sell or license? Nonexclusive licenses Exclusive license to firm 2 No licenses 1/3 1/(2-l3) 1/2 l*1 1 l1 Nonexclusive sale to firms 2 and 3 if (l1-l2-l3)(1-2l1) > l1l2l3 or no sale otherwise No sale Exclusive sale to firm 2 Licensing interim R&D knowledge

21. Conclusion • A leading firm in an R&D contest may be better off licensing or selling its interim knowledge rather then holding on to its lead • Selling is particularly attractive when the leading firm is very close to being successful because it allows to avoid competition • Licensing/selling is profitable because it may create value and may also allow the leading firm to extract rents from its rivals • Exclusive licenses may promote knowledge dissemination especially when the leading firm has a relatively high amount of knowledge Licensing interim R&D knowledge

22. Possible extensions • Endogenize the success prob. of the three firms • Add a second investment stage after licensing takes place - for example, the overall success prob. could be p(li,ti), where ti is the ex post investment • In such a model, licensing will allow the licensee(s) to save ex post investments • Replace Bertrand competition with some other type of competitive model • Make the success prob. private info. • Knowledge is non-Blackwell ordered • Cross-licensing agreements may emerge Licensing interim R&D knowledge