Balancing Power Between Biotech and Big Pharma Benefits Both

Opinion

Xconomy San Diego — 

Xconomy’s Luke Timmerman recently suggested that biotechs’ IPO option has shifted the balance of power between Big Pharma and biotech closer to parity, and the big guys have lost (or at least loosened) their iron grip on venture-backed biotech. As he put it,

The power dynamic between the two parties is the closest it’s been to an equilibrium in many years. More people will now be encouraged to start new biotech companies, to invest in them, and they will be fairly rewarded when successful.

This relationship is vitally important to the future of drug development—literally life or death for biotech in the short term and sustainability for pharma in the long term. Luke is right to focus on the importance of parity and access to money as the element that determines the balance of power. However, it will take more than an IPO window to redress that imbalance.

By any measure, 2013 was the best IPO market for the life sciences industry in over 25 years, and even that is not enough. IPO windows are too few, too brief, and too unpredictable to sustain an industry that lives hand-to-mouth in the financial markets. Since clinical outcomes and not market cycles drive success, entrepreneurs cannot count on money being available when they need it. As a result biotech will remain dependent on pharma for financial support.

As long as the basis of that relationship is limited to buy-sell transactions, biotech will remain at a disadvantage. In most deals pharma will have the upper (iron) hand in determining how the value is divided. Limited returns for biotech means a limited ability to attract capital, limited size, and ultimately limited ability to contribute to innovation in the pharmaceutical industry.

Pharma needs to broaden its relationship with biotech/bio-venture to include true discovery/development partnerships, and it needs to do it on a scale that exceeds anything contemplated today. Rather than partnering with a biotech only after it demonstrates a clinical proof-of-concept, pharma needs to pursue partnerships from the outset to create more new molecules and help advance them. As true operating partners, rather than adversaries in buy-sell transactions, pharma and biotech can bring to bear their respective strengths and minimize their weaknesses in the pursuit of new drugs.

Adam Smith made the case for the benefits of specialization a long time ago. The fundamental premise remains the same: small companies for small jobs; big companies for big jobs. Contract research organizations have demonstrated the scale of potential savings that can be realized by specializing in various stages of drug development. Relative efficiencies from externalization of early stage development could dwarf the savings realized in services.

In a partnering model, a private equity firm would raise a fund designed specifically to partner drug development projects in partnership with a pharma or a group of pharmas. The fund would operate like a venture fund, but with the express purpose of pursuing projects consistent with the partners’ strategic interests in the entrepreneurial community. NewCo portfolio companies would be organized with an option allowing the pharma sponsor to acquire the product at a pre-negotiated milestone and price. Ultimate responsibility for managing development would reside with the NewCo team. Pharma would pay only for success and only when it fits their strategic priorities at the time of purchase. By operating in more of a build-to-suit mode, biotech/bio-venture improves the odds of getting a timely buyer, and most importantly a buyer who has years of experience with the molecule and a sense of shared ownership.

Yet, pipeline priorities and pharma managers can change, even when molecules succeed. Un-optioned molecules could still be carried forward by the NewCo team if the original sponsor goes in another direction. This would reduce the opportunity cost to the industry of good molecules stalled or lost for reasons of strategic fit rather than performance. As the number of projects increases, the growing pool of un-optioned molecules in the venture/entrepreneurial community would enable pharma to draw and discard assets to optimize pipelines throughout the development process.

A partnership requires both sides to agree in advance on a program. Interests and economics must be aligned at the outset, rather than across a bargaining table, where the balance of power is tilted in favor of the deep pockets. Both sides would have to agree on a “fair deal” before proceeding; so risks and rewards would be consistent with contributions.

Partnering at the fund level, rather than in individual NewCos, would enable managers on both sides to develop a consistent and efficient interface across multiple deals, enabling pharma to leverage its human capital over many more molecules. The potential value of the total program reduces the incentive of either side to “cheat” and try to take advantage of the other on any single transaction. Each benefits from the long-term success of the other.

With massive layoffs in recent years, pharma has already made a de facto commitment to buy the products it needs to survive. If today’s conventional, venture-supported biotech industry fails to deliver the right mix of high-quality assets, pharma will be in serious trouble. Rather than waiting to see what the existing industry produces and hoping it meets their strategic needs, pharma can hedge that risk by supporting a number of these Partnered External Research and Development (PERD) funds.

To its credit, pharma is beginning to experiment with new business models along these lines. Discovery-development partnerships like the GSK-Avalon parallel investment program, the Lilly Capital Funds Portfolio-Atlas Development Corp Arteaus Project and Sanofi-Third-Rock-Warp-Drive partnerships are all examples of early stage pharma-bio-venture programs that show great promise. Pharma needs to run many more such experiments with both established venture firms and purpose-built teams.

PERD funds serve a different purpose from conventional venture funds: to integrate with their partners’ operations and serve their interests in the entrepreneurial community, and in doing so to make money for their investors. They need to be built with hands-on drug developers, capable of serving as true operating partners to pharma and working to the same standards as internal teams. PERD funds are designed to take on the high risk of operating in unexplored territory. They can test different approaches to early commercialization, at less cost, more quickly, in more different technical niches than pharma could alone. These partnerships would allow pharma to take initiative and seek out opportunities and assets in the entrepreneurial community to further their strategic goals.

From a financial perspective, fund managers make independent decisions and take full financial responsibility for outcomes. They manage their portfolios based on cost-of-capital investment strategies similar to those used by royalty funds. As a result, the funds are unlikely to provide the home-run opportunities that drive the most successful venture funds today. However, outsized returns are rare. By trading away those low-probability events, NewCo managers and the fund backers can maximize the probability of an efficient exit through hand-off to their larger partners. With the support of their pharma partners they can take on a broader range of smaller and earlier projects than established venture funds and integrate operations more closely with their sponsors.

Institutional investors are interested in new models for bio-pharma funds. Their investment can provide outside money for financial leverage. However, to create early stage partnerships designed to align with their strategic goals, pharma has to commit both money and human capital before financial investors will consider joining. A relatively small amount of funding—a few hundred million—leveraged with institutional money, could have a catalytic effect on the development of a broad early stage industry. With leadership from pharma, the entrepreneurial community would respond aggressively to the need for new products.

The creation of an early stage industry is a critical-mass phenomenon. Today’s isolated experiments in commercialization won’t demonstrate the large-scale synergies available in a broader marketplace of assets and ideas. As Silicon Valley has shown, when entrepreneurs, technicians and investors come together in the right mix and sufficient numbers, innovation begets more innovation.

Drug companies have responded to the challenge of innovation by sponsoring research collaborations and incubators, but gaps in the chain of development remain. Pharma has a unique opportunity to expand the biotech/bio-venture landscape to include shared external development models and foster an early development industry. All the pieces are there–VCs, entrepreneurs, industry personnel; they simply need to be aligned with phama’s strategic interests. The managers of independent sponsored funds are uniquely positioned to do that. The industry, both individually and collectively, needs to test more approaches and more management teams to find timely answers to the challenge of innovation.

IPO windows, while welcome, won’t solve the problem. So pharma must redress the BigCo-SmallCo balance, relax its iron grip, and take seriously its small innovative partners.

Standish Fleming is a 29-year veteran of early stage, life sciences investing. He has helped raise and manage six venture funds totaling more than $500 million and served on the boards of 19 venture-backed companies, including Nereus Pharmaceuticals, Ambit Biosciences, Triangle Pharmaceuticals (acquired by Gilead Sciences) and Actigen/Corixa (now part of GSK). Follow @

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One response to “Balancing Power Between Biotech and Big Pharma Benefits Both”

  1. DrBonnie360 says:

    In terms of cross disciplinary pollination to speed up innovation across biotech and pharma, there is also a need to include the data science community-who bring concepts of data sharing and open data.