Eating Our Seed Corn

The drug industry's preoccupation with late-stage products means they're largely ignoring early-stage companies. But unlike earlier years, these biotechs have no financing alternative: the stock market now marches in lockstep with Big Pharma trends. But as the extraordinary valuations of the large biotechs shows, the early-stage companies of today can be the late-stage companies of tomorrow--and the source of Big Pharma's late-stage product opportunities. If drug firms don't act now to encourage early-stage investment--either through lobbying for governmental investment incentives or through their own venture investing--they may, in focusing so exclusively on late-stage deals, be eating their own seed corn.

The pharmaceutical industry is having a millennium anxiety attack.

Over the last twenty years, since the founding of Genentech Inc. , the drug industry has gone full circle, from a slowly and then rapidly expanding faith in the limitless promise of pharmaceutical technology to an equally intense awareness of scientific risk.

The major manifestation of the drug industry's worry is its preoccupation with the acquisition of late-stage products which companies are buying to reduce their overall new product investment risk. But companies pay a price in margin for this investment security. As more drug firms leap on the bandwagon—recognizing that a late-stage product acquisition might actually pay off better than their own internal research investments—the increasing competition bids up prices.

In most of the world, higher costs lead to lower profitability. Pricing is out of corporate hands. In the wonderland of the United States, companies can still increase prices. But then their policy arguments weaken. They can't without challenge maintain–in response to the growing calls for price controls–that their new high-cost medicines result from their daring research investments. The whole point of the drug industry's focus on late-stage products is to reducethe risk of research—to foist that responsibility on others. It's tough to credit PhRMA lobbyists who talk about the drug industry's high-risk research spending when their members are busy marking up the acquired fruits of other companies' research in order to make their normal drug margins.

So who's taking the investment risk? It's become increasingly obvious that it's been biotech investors—the poor saps who bought Centocor Inc. and Immunex Corp. stock at the outrageous prices for which they were selling in 1992 and before, and with whose money the biotechs funded the development of drugs like ReoPro, Remicade, and Enbrel (not to mention the disappointments that accompanied them).

Big Biotechs are now among the darlings of the investment community, whose passion has been inflamed by Big Pharma's equally warm regard. Drug firms are willing to pay substantial premiums to acquire what have now effectively become mid-size drug companies—with their currently marketed products, their late-stage pipelines, and their comparatively more productive research organizations.

Not so long ago, many of these companies couldn't buy a hearing with a top business development executive. And now the same is true for hundreds of smaller biotechs with preclinical or early clinical data. If most small caps want to attract Big Pharma support, the deals they must offer are suicidally dilutive—heavy on cheap equity, light on retained marketing rights.

That's not radically different from the situation four years ago, of course, except for one major change: the stock market. Sans Big Pharma support, investors were still willing to take a flyer that a drug near or in clinical trials was worth supporting, at least until it generated enough human data to interest a drug company licensee.

No more. Unless a biotech's got a product at least in Phase III, few investors are willing to lay out cash better spent on Internet deals. In biotech today, Wall Street marches in lock-step to Big Pharma's investment beat. If drug companies are willing to put big money into a company, so will Wall Street. But in the rush to late-stage products, drug firms have to a significant degree withdrawn from supporting early-stage programs at biotechs. So, accordingly, have investors. And without supportive financial markets, biotechs are not going to be doing much development.

Pharmaceutical R&D is as fragile as any other complex business ecosystem. Remove part of the food chain and much else collapses. Biotech executives have always argued, with self-encouraging overstatement, that they are the future of the pharmaceutical industry. At least some of them have turned out to be right, or so executives at Johnson & Johnson , Warner-Lambert Co. , and Abbott Laboratories Inc. , all recent acquirers of large biotech companies, are hoping.

The disaster scenario is that drug firms won't have a new crop of Big Biotechs to feed on. That's probably a bit hysterical. Once the easy pickings are gone, the drug firms will turn to the next best thing, earlier stage biotechs—and as they do Wall Street will turn with them.

Granted, of course, that there are enough biotechs with worthwhile projects still left. In previous biotech winters, executives and investors seemed to know that the investment season would turn. And given that certain prospect, shareholders by and large didn't force liquidations.

But the investors and biotech executives we speak with have no such confidence today. While company sales are always a strategic choice of last resort, the choice is coming to consideration far earlier now. Among the many programs destroyed in the consolidation will be more than a few gems.

In effect, without a strong stock market encouraged by a supportive investment program from Big Pharma, the late-stage preoccupations of drug companies mean that they are simply eating their seed corn. So what's to be done?

We've argued, and think PhRMA should, too, for the reintroduction of some form of tax-advantaged R&D partnerships, to encourage investors to support early-stage, higher risk work that in this frothy Internet market simply won't get funded. There are also a number of proposals now being bruited about, including a general BIO-affiliated investment fund, and several company-specific ones. All seem like possibilities drug companies should make a priority of exploring.

The point is that biotechs wouldn't be the only beneficiaries of such programs. The top predators in the food chain will thrive only as long as their prey does.