Risk sharing in licensing

Summary In this paper we study the choice of financial clauses in a license agreement when demand and/or cost are uncertain. We consider contracts with three instruments: a flat fee, a per-unit fee and an ad valorem fee. We characterize the optimal contract and determine the appropriate combination of instruments to use. Whatever the source of uncertainty, the optimal contract is based, in general, on a combination of a flat fee and a royalty. However, the source of uncertainty plays a crucial role in the choice of the type of royalty. When demand is uncertain (while cost is not), the optimal contract combines a flat fee with an ad valorem charge. In this case, it is never optimal to use a per-unit charge. When cost is random (but demand is not) a wider variety of solutions emerge. Depending on the value of the structural parameters, the contract should have a flat fee associated with one or other of the fee types, or may even use all three instruments.