Business models of the biopharmaceutical industry: A story of wasteful strategies

The pharmaceutical industry has followed a vertically integrated business model for a long time.63 However, the emergence of biotechnology64 has made the drug business more complex due to the introduction of both a new set of participants and a new sectoral logic.65 In the early 1980s the vertical integrated model became the blueprint for the first wave of biotech companies,66 which came to be known as FIPCO model (fully integrated pharmaceutical company). This first generation of integrated startups was initially expected to compete on equal terms with pharmaceutical companies. However, investors’ enthusiasm rapidly dried up when they realized that biotechnology was far from providing a low-risk approach to drug development. Companies of subsequent business models (e.g. technology-platform), abandoned vertical integration and became dependent on licensing their technologies to big pharmaceutical companies (R&D monetization). Consequently, todays differentiation between pharma and biotech has become fuzzy.

R&D monetizing strategies consist of the commercial exploitation of intellectual property; often in form of exclusive licenses agreements and/or strategic alliances. An intellectual property' license is a contract by which permission is given by the licensor to the licensee to exploit the licensors intellectual property.67 In the pharmaceutical sector, most intellectual property licenses are granted on an exclusive basis, which means the right to exclude others (including the licensor68) from exploiting the intellectual property (Kesselheim 2010). A strategic alliance is a relationship where two parties contribute their different but complementary resources and capabilities to achieve a common objective.69

A strategic alliance will almost invariably involve a license. However, while a license is fundamentally a passive relationship in the sense that the licensor, having granted the license, is not required to do anything else, the granting of a license by one alliance partner to the other is likely to be only one of the contributions that one alliance partner makes to the alliance. Strategic alliances in the pharmaceutical sector will generally fall into one of two categories: Co- Development and Co-Marketing Agreements. In the biopharmaceutical sector the financial terms of both license and alliances are usually a combination of (1) up front payments, which are paid upon the signing of the contract (2) milestone payments, which are paid as particular milestones along the development, clinical and regulatory pathway are reached, and (3) royalties, once there is a product in the marketplace.70

These strategies found their momentum in 1980 when the Bay-Dole Act allowed federal funded research to be patented in the US.71 The introduction of this Act served as an incentive for small specialized biotech firms, mostly stemming from universities, small public labs, etc., to patent their discoveries and to license them to big pharma companies after the proof of concept (phase II) was established. Big pharma companies, which have been finding it more difficult to develop innovative drugs72 then take charge of large-scale phase III,73 regulatory approval, distribution and marketing, and small biotechs receive royalties in exchange.

After exclusive marketing rights expire, copies (generic drugs) enter the market, and the price usually falls to as little as 20 percent of what it was. In order to extend this exclusivity, the Hatch-Waxman Act was enacted in 1984,74 which provided longer and more frequent extensions for drug patents. Until 1984 US patent legislation had treated medical discoveries in the same way as other innovations, but the introduction of this law represented a real boost to the outsourcing strategy mentioned above. The main reason for this is that it allows pharmaceutical companies to focus on sales and marketing, while letting smaller firms to develop product for existing markets and existing treatment modalities.

According to Pisano (2006 pp. 176—8) this model has proven commercially successful (in the short term) for less novel products or me-too drugs. The development of these drugs require less investment in specialized downstream assets; i.e. clinical, marketing and distribution infrastructure, and they can be differentiated in the market through advertising. For instance, “although Pfizer lost market exclusivity for atorvastatin, venlafaxine, and other major sellers in 2011, revenues remained steady compared with 2010, and net income rose 21 percent” (Light and Lexchin 2012, p. 2). From 1960 to 1980, prescription drug sales were fairly static as a percent of US gross domestic product, but from 1980 to 2000, they tripled.75 From the perspective of an established pharmaceutical company, it makes sense to focus most research on extending or replacing existing best-selling drugs, in order to expand its patent protection and to avoid competing with generics. However, broader and longer patents of minor variations of existing drugs forces pharmaceutical companies to waste precious resources for no good social reason.76 The current ratio of basic research to marketing in 2012 was 1: 19 (ibid.).

Likewise, it could make sense from the point of view of a specialized small company to position itself into a small segment of the industry value-chain and to enter into strategic alliances with larger pharmaceutical companies.This became regular practice in the 1990s, when new technological advances related to the Human Genome Project created a new stream of biotech specialized entrepreneurs more focused on tool based/technology platform model.77 They were supposedly to be able to generate faster revenues than the FIPCO model through royalties, milestone payments, licensing and services fees or subscriptions.

However, in practice, the typical contract duration for R&D alliances with established pharmaceutical firms is around four years, which is three times shorter than the typical product development cycle (Pisano 2006, 179). Companies under pressure from quarterly reports have difficulty justifying long searches for breakthrough drugs to investors (Light and Warburton 2011). Alliances deals are usually employed as a tool to signal good prospects to potential investors rather than to build long-term oriented collaboration. Indeed, the persistent low R&D productivity' of the industry is proving that deals alone do not create value. More important is how the partnership uses the capital it raises and how well it creates value from its activities. Unfortunately, since the 1980s, companies have always found themselves to be more embedded in an institutional environment, where stock market valuation78 plays the crucial role in the business model of the industry.

When the start-up does an IPO79 the big pharmaceutical partner can get a return to its R&D investment by cashing in the equity stake it has as part of the R&D contract. Deals are focused on meeting specific short-term milestones in order to fulfil quarterly expectations. To fail meeting a milestone could mean the termination of the alliance. This kind of partnership management shows little commitment beyond a single project, which prevents partners from taking innovation-boosting, entrepreneurial risks, e.g. investing in specialized assets, learning jointly or sharing proprietary information.

In this context, the true commercial value for technology platform companies, universities, public research organizations and overall R&D entities resides in the ability to generate proprietary knowledge and to protect it via patents.These patents are exclusively licensed to existing firms or start-ups that try their luck with venture capitalist investors.80 But the ability' to do an IPO, even without a product, is the major inducement for venture capitals to fund the biotech industry, since it does not have to wait until revenues are generated from a product to get returns on its investments (Lazonick and Tulum 2011). Venture capitalists have a time frame of about three years (Pisano 2006, pp. 139,

155), while the product development time in the biotechnology industry is much longer.

The reason for this time-frame is that closed-end funds are raised from institutional investors for a ten-year period,81 and the VCs are then under pressure to have the funds invested and return to the institutional investors within this time-frame. For example, during the period 1991—2004,88 percent of biotechnology' companies were making IPOs, but only 20 percent had any product on the market).The vast majority were still in pre-clinical and discovery phases (ibid., p. 143).This is highly problematic role of venture capitals, because it runs in opposite direction of what long-term product innovation need, especially in the biopharma industry. No wonder that the financial crisis started in 200882 significantly lowered prospects of returns from IPOs and almost erased venture capitals from the funding menu of the biopharmaceutical companies worldwide (E&Y 2011 and 2012).

Similar to the FIPCO companies, specialized firms raised quick expectations among stock and VC investors, and shortly thereafter, skepticism and disappointment.83 In fact, platform technology companies such as Millennium and Celera vertically integrated into drug R&D and began to develop their own products. In this way, they adopted the same model of the first generation of entrants of the previous two decades. However, in actual fact, the map of the industry continues to be determined by the proliferation of a huge number of specialized small “expertise islands,” which have been proved to be inadequate from both industry84 and economy points of view.85

It is hard to overemphasize that this model has clearly proven counterproductive for more innovative drugs. One of the most important reasons being that the tacit nature of the knowledge being created in the industry and the extreme complexity and complementary character of the discovery process within the industry, makes it almost impossible for companies without integrated in-house (or long-term collaboration) capabilities to grow into a sustainable scale. The strong interdependence between a target (particularly if novel), the molecule’s structure and its physical properties, the dosage form, the manufacturing/distribution process, the design of appropriate clinical trials and the patient population play a crucial role in the performance of a product. It is virtually impossible to isolate one component without considering the implication for the other elements.

In addition, the absence of codified standards platform (like in the semiconductor or software industry) does not simply allow a problem to be easily broken into a set of relative independent modules (the auto industry is a good example of modularity) (Pisano 2006, pp. 149—52). This is maybe one of the reasons why positive performance in the industry has been concentrated in few vertically integrated or FIPCO companies (Amgen,86 Genentech,87 Genzyme, Biogen,88 Chiron,89 Biovail etc.) (ibid., p. 116). In 2004 Amgen and Genentech accounted for more than the 53 percent of the cash generated by the sector (ibid., p. 115).

In this industry vertical integration has reduced the risk of operating under a regime of radical uncertainty, difficult-to-transfer tacit knowledge, specialized assets and unclear intellectual property' issues. Likewise, it has allowed the rapid diffusion of knowledge and information; and has contributed to long-term cumulative learning. Indeed, as observed in Chapter 4 (Section 4.9), instead of looking at (downstream or upstream) integration only as way to monopolistic control (neoclassic vision) or as an optimal response to market failure (transaction cost theory) one should analyze the roles of horizontal and vertical relations among enterprises within a particular industry by promoting collective and cumulative learning.

However, it is important to point out that such an organizational integration requires firms to develop internal capabilities to integrate the complex pieces of the biopharmaceutical R&D; and this is not an automatic process. Vertical integrated firms may (and have) become containers of islands of expertise that operate isolated from each other. In addition, vertical integration in the biotech world makes it more difficult to pursue diversified R&D portfolio strategies, given the huge amount of investment required to fund downstream assets (Pisano 2006, p. 172). In order to hedge (but by no way eliminate) this risk, vertical integrated firms need to have at disposal a huge network of specialized collaborators (suppliers, distributors, subcontractors) and; most important, a committed source of funding that allow them to engage in the complex and uncertain process of cumulative search and experimentation that innovation entail, until they are able to generate higher quality, lower cost products. That is the kind of commitment shown by government agencies such as the US- National Institutes of Health (NIH).

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