<p>In many vertical markets, licensing agreements are common. One instance of these contracts is between manufacturers and distributors, whereby the manufacturer permits the distributor access to its produce which the distributor may then sell on to retailers/consumers. I will focus on these manufacturer/distributor licensing agreements.</p>
<p>These licensing contracts may be complex, with transfers between the manufacturer and distributor contingent on certain milestones being met (e.g., earning a certain amount of  revenue from licensed products, selling a specified quantity of licensed products, etc.). Although these agreements are filed with the relevant regulatory body (e.g., the SEC in the US), the filings often have redactions so that the exact terms of the agreement are not publicly known. My question is whether there is some economic rationale behind this confidentiality. That is, why would the manufacturer and distributor benefit from their licensing contract being unobservable? I am primarily interested in this confidentiality with respect to the format of the milestone payments.</p>
<p>To me, there are three main reasons to have milestone payments. (1) Milestone payments may be a response to a downstream moral hazard problem if the incentives of the manufacturer and distributor are not aligned. For instance, the manufacturer may want the distributor to maximise sales whilst the distributor may be profit maximising. (2) Milestone payments may work to resolve a hold-up problem if the manufacturer and distributor must make ex-ante relationship specific investments. Rebate schemes (a form of milestone payment) by the manufacturer are often given in exchange for exclusive dealings which can resolve the issue of hold-up. (3) Milestone payments may serve to countervail market power held by large downstream retailers. For example, large milestone payments from the distributor back to the manufacturer may disincentivise the distributor from trading with the retailer except at high prices. If these milestone payments are known by the retailer, then they will be forced to offer higher prices if they still wish to trade.</p>
<p>Points (1) and (2) do not depend on the public observability of the licensing contract since they are only reliant on both the manufacturer and distributor knowing the terms of the contract. Point (3) does require public observability of the contract so that the retailer knows at what prices the distributor is willing to trade. So from these points, it seems that observability is never a bad thing for the manufacturer or distributors. Additionally, if the manufacturer deals with multiple distributors, unobservability of its licensing contracts may in fact harm the manufacturer since it cannot commit to not secretly renegotiating away from the monopoly level of inputs with some distributor (Rey and Tirole, 2006).</p>
<p>For what other reasons might the manufacturer want to offer milestone payments? And do any of them depend on the licensing contract being unobservable?</p>

CC BY-SA 4.0
2024-08-22T19:57:09.830Z
“*large milestone payments from the distributor back to the distributor may disincentivise the distributor from trading with the retailer except at high prices*” --- Should the last two instances of "distributor" have been "manufacturer" instead?
Herr K.
CC BY-SA 4.0
2024-08-22T19:58:22.407Z
I don't have an answer, but would be interested in a pointer to examples of such redacted license agreements.
Herr K.
CC BY-SA 4.0
2024-08-23T07:59:04.427Z
@HerrK. Thank you, the second distributor was a typo. For examples, Merck Sharp & Dohme Corp. signed a licensing deal in 2014 with Ablynx N.V. where Ablynx agreed to give Merck a Patent and Know-How license. The agreement has most of the milestone payments redacted. There are more examples, but I wanted the question to focus on economic theory rather than more practical considerations of specific cases.
Joseph Basford
<microeconomics><industrial-organisation><competition><contract-theory>
Why do Unobservable Licensing Contracts Exist?
Joseph Basford
# Why do Unobservable Licensing Contracts Exist?

(Asked by: username_0 on 2024-08-22)

In many vertical markets, licensing agreements are common. One instance of these contracts is between manufacturers and distributors, whereby the manufacturer permits the distributor access to its produce which the distributor may then sell on to retailers/consumers. I will focus on these manufacturer/distributor licensing agreements.

These licensing contracts may be complex, with transfers between the manufacturer and distributor contingent on certain milestones being met (e.g., earning a certain amount of revenue from licensed products, selling a specified quantity of licensed products, etc.). Although these agreements are filed with the relevant regulatory body (e.g., the SEC in the US), the filings often have redactions so that the exact terms of the agreement are not publicly known. My question is whether there is some economic rationale behind this confidentiality. That is, why would the manufacturer and distributor benefit from their licensing contract being unobservable? I am primarily interested in this confidentiality with respect to the format of the milestone payments.

To me, there are three main reasons to have milestone payments. (1) Milestone payments may be a response to a downstream moral hazard problem if the incentives of the manufacturer and distributor are not aligned. For instance, the manufacturer may want the distributor to maximise sales whilst the distributor may be profit maximising. (2) Milestone payments may work to resolve a hold-up problem if the manufacturer and distributor must make ex-ante relationship specific investments. Rebate schemes (a form of milestone payment) by the manufacturer are often given in exchange for exclusive dealings which can resolve the issue of hold-up. (3) Milestone payments may serve to countervail market power held by large downstream retailers. For example, large milestone payments from the distributor back to the manufacturer may disincentivise the distributor from trading with the retailer except at high prices. If these milestone payments are known by the retailer, then they will be forced to offer higher prices if they still wish to trade.

Points (1) and (2) do not depend on the public observability of the licensing contract since they are only reliant on both the manufacturer and distributor knowing the terms of the contract. Point (3) does require public observability of the contract so that the retailer knows at what prices the distributor is willing to trade. So from these points, it seems that observability is never a bad thing for the manufacturer or distributors. Additionally, if the manufacturer deals with multiple distributors, unobservability of its licensing contracts may in fact harm the manufacturer since it cannot commit to not secretly renegotiating away from the monopoly level of inputs with some distributor (Rey and Tirole, 2006).

For what other reasons might the manufacturer want to offer milestone payments? And do any of them depend on the licensing contract being unobservable?

**Tags:** microeconomics, industrial-organisation, competition, contract-theory

> **Comments:**
> **username_1**: “*large milestone payments from the distributor back to the distributor may disincentivise the distributor from trading with the retailer except at high prices*” --- Should the last two instances of "distributor" have been "manufacturer" instead?  
> **username_1**: I don't have an answer, but would be interested in a pointer to examples of such redacted license agreements.  
> **username_0**: @HerrK. Thank you, the second distributor was a typo. For examples, Merck Sharp & Dohme Corp. signed a licensing deal in 2014 with Ablynx N.V. where Ablynx agreed to give Merck a Patent and Know-How license. The agreement has most of the milestone payments redacted. There are more examples, but I wanted the question to focus on economic theory rather than more practical considerations of specific cases.  

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## 0 answers

