Tacit Knowledge and the Structure of License Contracts: Evidence from the Biomedical Industry

How do contracts deal with the exchange of tacit knowledge, which is difficult to observe, enforce, and verify? This study compares the sample characteristics of 505 license agreements between inventors and developers of biomedical inventions with theoretical prescriptions about contractual terms when the parties’ tacit knowledge is required to commercialize the inventions. The analysis reveals that (a) three‐ and four‐part payments are common in licenses of biomedical inventions; (b) the importance of inventors’ tacit knowledge in development activities is directly related to the magnitude of royalty rates in the licenses; and (c) the importance of developers’ tacit knowledge in development is associated with minimum annual payments when the license includes measurable benchmarks to address the shelving of inventions, and to upfront payments in the absence of such benchmarks. Firms use a complex mix of upfront and state‐contingent payments, broadly consistent with theoretical prescriptions, to cope with the incentive issues inherent in the exchange of tacit knowledge.