Article: Financing Innovation: Branding, Monitoring, and Uncertainty

A recent breakthrough in contract theory identified the practice of braiding, in which parties weave informal and formal elements of contract together to overcome uncertainty.  These contracts are especially prevalent in the context of collaboration for technological innovation, but they also appear in other contexts with significant uncertainty, such as preliminary agreements in mergers and acquisitions.  Thus far, the literature has focused solely on the core contractual relationship—the crystallized instance of the initial agreement between two companies, such as a research collaboration between a large pharmaceutical company and a small biotechnology company.

This article builds on braiding theory in several ways.  It provides new empirical information by analyzing actual contracts, modifications, and financing arrangements.  It expands braiding theory’s initial inquiry and seeks to understand how modifications to such original agreements affect braiding and how secured lenders finance such uncertain collaborations and monitor debtors.

Modifications reveal how parties gradually resolve uncertainty and how they respond to newly arising uncertainty.  First, modifications have shifted power within the “contract referee mechanism,” suggesting that braiding also works well as a mechanism to deal with ex ante uncertainty of bargaining power, revelation of information throughout the relationship, and ex post reallocation of that power.[1]  Second, modifications have formalized certain switching costs in termination provisions, and have adjusted those costs over time.[2]  This formalization suggests that crowding out of informal elements (here, switching costs) is not a necessary result even when there is a high-powered formal element.  Third, modifications reveal innovative nested option structures[3] that are developed in stages as nested uncertainty is revealed.[4]  Low-powered formal mechanisms[5] appear to be essential in developing an option-based response to these unforeseen uncertainties.

The secured lender’s behavior in these contracts is initially puzzling: neither the braiding solution nor the traditional secured credit solution is present to resolve uncertainty or even manage the risk of routine opportunism.[6]  The secured credit theory predicts that the lender will take one of two measures to police opportunism: monitor the debtor’s behavior or accept a bonding gesture by the debtor.[7]  Here, neither of those occur in any significant way.  The lender cedes control over the primary assets of the small collaborator, the intellectual property (IP), and allows the big collaborator an exclusive license.  The lender also does minimal monitoring: it might receive financial statements, but it does not actively monitor debtor behavior, the collaborative process, or the collateral.  Instead, the lender’s primary strategy is to take a security interest in the small company’s payment rights from any IP that emerges from the collaboration.

This article solves the puzzle with two steps that refine foundational assumptions in secured credit theory and the theory of transacting around uncertainty.  First, it is not the secured lender who monitors the debtor, but the big collaborator.  The big collaborator’s monitoring acts as a substitute for the secured lender’s expected monitoring.  Secured credit theory typically describes the secured lender as a “cop on the beat,” which allows other unsecured creditors to provide credit without worrying about monitoring.  Here, the big collaborator is the “cop on the beat,” and it is the secured lender who is benefitting from that diligence.  This particular monitoring arrangement is also normatively optimal as the secured creditor does not have the usual combination of countervailing effects—focused monitoring and security’s disincentivizing insulated recovery.[8]

Second, Knightian uncertainty is relative.[9]  The underlying uncertainty problem that braiding contracts attempt to solve is not an absolute attribute of a particular event or series of events as economics literature has typically suggested.  Instead, one’s economic position with regard to specific uncertainties can transform an uncertain event into a risky event.  This result can be seen in the secured lender’s strategy.  The big and small collaborators effectively solve the uncertainty problem in their technological innovation contract, but the uncertainty is not automatically solved for other parties.  Unlike the elimination of risk by monitoring, the uncertainty is still present and will not dissipate until the necessary information is revealed (or created).  The secured lender, however, cares nothing of this uncertainty and instead makes a bet on the exogenous probability of the success of the venture.  The uncertainty endogenous to the collaborative relationship determines that outcome, but need not be a part of the secured lender’s risk calculus.[10]  For example, any collaboration may have a ten percent chance of success, but the direction of each individual collaboration may be radically uncertain.  By having a position outside of that relationship, the secured lender has a different relative position and can avoid the uncertainty problem inherent in braiding contracts.  Portfolio theory provides a more rigorous explanation of this phenomenon by describing how specific uncertainty may be diversified away, a fact previously undeveloped in economic and legal academic literature.

Part II describes the theoretical background for this discussion.  It describes the phenomenon of braiding contracts and how they solve problems of technological and partnership uncertainty.[11]  It also considers alternative theories that seek to explain how the uncertainty problem has been solved, such as modularity theory and relational contracting theory.  It also examines prior empirical literature on collaborative alliances and questions its underlying assumptions about contracts underlying this literature.

Part III examines a new example of a prototypical braiding relationship and its contractual modifications as that relationship developed over time.  Specifically, it examines how modifications affect the contract referee mechanism, switching costs, and the nested options structure.  The modifications of these features reveal that braiding also deals with uncertainty of bargaining power[12] and unforeseen uncertainties which only emerge once the relationship has developed.  The formalization of switching costs through high-powered mechanisms also further undermines the explanatory power of the crowding-out phenomenon in the economics literature, but perhaps only where the formal and informal elements of the contract are tied to different information streams.

Part IV examines the third-party loan agreement with the small collaborator in that relationship.  The actual structure of this loan agreement undermines the standard predictions one would make under current theories of secured credit and policing debtor opportunism.  This analysis discerns a new pattern of monitoring, helps to refine existing secured credit theories and adds a new tool for solving puzzles in explaining the pattern of secured credit.

Part V considers the loan agreement’s approach to the collaboration’s uncertainty, finding that the only plausible explanation is that Knightian uncertainty is positionally relative.[13]  The secured lender is actually operating under a risk-based scenario despite the uncertainty inherent in the collaboration that it is lending into.  After describing intuitive analogies for this argument, this Part adds a first cut at using portfolio theory to establish a rigorous basis for the relativity of uncertainty.  The Part concludes by considering what the relativity of uncertainty means for the role of business lawyers in such transactions.

Part VI concludes.

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Nicholas J. Houpt: Associate, Akin Gump Strauss Hauer & Feld LLP.  J.D., Columbia Law School; B.A. University of Notre Dame.



[1]. Ronald J. Gilson et. al., Braiding: The Interaction of Formal and Informal Contracting in Theory, Practice, and Doctrine, 110 Colum. L. Rev. 1377, 1403 (2010) [hereinafter Gilson, Braiding].  A “contract referee mechanism” is a dispute resolution mechanism used in braiding contracts.  Id.  The mechanism typically requires (near) unanimous consent for certain key decisions in the collaborative relationship.  Id.  Lower-level employees are typically the ones deciding at first, with any unresolved disputes going to higher-level employees.  Id.

[2].Id.  Switching costs are the costs of finding another partner with whom to collaborate.  Gilson, Braiding, supra note 1, at 1403.  These costs include the learning curve that the new partner would have to undergo to catch up to the current partner, and would include a discount for reliability and trust that has not yet been established.

[3]. See id. at 1407-09.  Nested options are a mechanism used to solve potential hold-up problems that may arise once uncertainty is dissipated.  For example, once a technological innovation is developed, the next stage is commercialization.  One can predict these stages beforehand and use an option structure at each stage to prevent opportunism.  One collaborator may have an option of first refusal on the commercialization of any product that is developed, and if that collaborator cannot reach a commercialization agreement with the other, the other has an option to purchase the product and commercialize it through other means.  Without these options, the parties might try to hide their successes from each other and act opportunistically.

[4]. In this article, I challenge the effectiveness of nested options by pointing to evidence of nested uncertainty.  As one type of uncertainty is resolved and a predictable stage is entered, another type of uncertainty may develop that presents its own opportunism problems.  This unpredictable uncertainty can only be dealt with once it arises.

[5]. Low-powered formal mechanisms are soft commitments, like an obligation to negotiate in good faith.  High-powered formal mechanisms are much harder commitments, such as the obligation to perform a certain task at a certain time.  In the context of braiding contracts, low-powered formal mechanisms are used because hard terms, like price, quantity, and typical covenants, do not fit well with uncertain processes.  The options that are typically used are options to negotiate about a particular term or to terminate the agreement.

[6]. I explain other standard theories of secured credit not discussed in the Introduction, such as relational contracting and contextualist theory in Part IV.

[7]. See Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 Yale L.J. 49, 50-59 (1982) (describing monitoring and bonding as the two methods secured lenders use to manage agency costs).  See infra Part III.A for a more thorough discussion of the many different theories of secured credit.

[8]. See infra Part IV.C (discussing Richard Squire’s theory of symmetry in creditor’s rights).

[9]. Knightian uncertainty and risk are categories of risk proposed by the economist Frank Knight.  See generally Frank H. Knight, Risk, Uncertainty and Profit 197-232 (1921).  Risk is quantifiable and can be probabilistically allocated, whereas uncertainty is so radically unquantifiable that any allocation of risk would be arbitrary.

 

[10]. A familiar analogy might be the way that venture capitalists fund start-up firms.  The venture capitalist does not care that the entrepreneur wanted to invent a war-time anesthetic for soldiers and ended up with Novocain, a product that was successful in a different market; the venture capitalist looks for an innovative product with a chance of success.  Once found, the venture capitalist typically provides funds in exchange for equity, and the venture capitalist sells off a large portion of that equity once the product has succeeded.

[11]. Partnership uncertainty is the uncertainty involved in finding a collaborator whom one can trust, who will fit well with one’s working style, and who has the skills and know-how to make a successful collaboration.  Each of these things is difficult to signal before the collaboration begins, leaving these qualities uncertain ex ante.  As the collaboration proceeds, one can establish informational mechanisms to observe these qualities in the partner.

 

[12]. Uncertainty of bargaining power refers to the parties’ inability ex ante to determine which party is least likely to defect when given an ex post decision right.  In other words, it is not clear which party has the most to gain or most to lose in any future state of the world.

[13]. Positionally relative might mean several things and this article is only a first cut at clarifying the concept.  Uncertainty can be relative to one’s economic position, which would differentiate between the lender and the big collaborator, who each have very different economic transactions with the small collaborator and hence each have different concerns about uncertainty.  The other possibility is that uncertainty is relative to legal position.  The legal structure of the loan can be asset-based or cash-flow based and this structure might change how much uncertainty matters to the lender.

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