In-Depth Analysis of the Biotech Industry: Navigating Through the Fog of Limited Knowledge and Experience

If we look back at China's Biotech industry in 2022, there are two well-known keywords: source innovation and clinical needs. These two terms are the result of industrial reflection. The industry, which has experienced rapid growth, begins to more thoroughly reflect on its past development model in the cold winter, and seeks new growth points.

At the end of 2006 and the beginning of 2007, the United States also experienced a wave of reflection on Biotech. If the establishment of Genentech in 1976 is considered the starting point of the first wave of innovation in the U.S. biopharmaceutical industry, by 2006, the industry had already gone through 30 years.

In its 30 years of development, the biotechnology industry has attracted more than 300 billion US dollars in capital. A few biotech companies, like Genentech, have grown into bioPharmas, while most biotechs have completed a leg of the innovation relay. Biotechnology seems not to have fulfilled its promise—rapid breakthroughs in basic science—but through continuous attempts, it has allowed people to constantly reflect and face up to having reasonable faith, expectations, and practical applications of science.

In 2006, an article was published in the Harvard Business Review. The author of the article conducted extensive research over a 20-year period on the strategy, structure, performance, and evolution of the U.S. biotechnology and pharmaceutical sectors. He pointed out,"The biotechnology industry has largely drawn on mechanisms that work well in software, computer, semiconductor, and similar industries. However, when these mechanisms are applied to the biotechnology industry, they have fundamental flaws and cannot simultaneously meet the needs of basic scientific research, industrial transformation, and commercialization."

Although this is an old article, it is still highly enlightening for the current biopharmaceutical industry when viewed as a mirror of history.

VCBeat appropriately shortened and edited the original text without changing its meaning to form this article.

Products from the first wave of biotechnology companies such as Amgen, Biogen, Chiron, Genentech, and Genzyme were proteins discovered in the human body. At the time, it was believed that these products had a much lower risk of failure during development compared to traditional chemical drugs. Additionally, the initial success of some genetically engineered alternative hormones—such as insulin, human growth hormone, and Factor VIII for treating hemophilia—seemed to confirm this belief.

Lower technical risks imply lower commercial risks. The excitement surrounding these emerging technologies has led to an explosive growth in the number of biotech startups (approximately 4,000 over the past 30 years), and the industry’s annual revenue has similarly surged (currently around $40 billion), reinforcing optimism about the biotech sector. However, when assessing the overall profitability of the industry and the number of breakthrough drugs resulting from revolutionary R&D advancements, a troubling picture emerges.

First, only a small number of Biotech companies have achieved profitability or generated positive cash flow, with the entire industry experiencing losses. Among the companies that have become profitable, only a few of the oldest ones (including Amgen, Biogen, Genentech, and Genzyme) have generated substantial profits, with only Amgen and Genentech breaking into the ranks of established pharmaceutical companies.

Notably, both Amgen and Genentech have achieved vertical integration through significant investments in production and marketing. Genentech has established a long-term partnership with the Swiss pharmaceutical giant Roche, which owns 56% of Genentech's shares.

Secondly, there is no sign that biotechnology has revolutionized the R&D productivity of the pharmaceuticals industry. The average cost of developing a new drug by Biotech shows no significant difference from the average cost of large pharmaceutical companies. Industrialized R&D has not significantly increased the number of compounds used in human clinical trials, let alone the number of drugs entering the market.

Not surprisingly, Biotech appears to have shifted its aggressive, high-risk R&D model. Since the genomics bubble burst in 2001, there has been a notable shift in both startup strategies and venture capital preferences. Entrepreneurs and investors have started seeking lower-risk, quicker-return models, such as licensing existing projects and products from other companies and then refining them. This strategic shift has sparked a major concern: if startup Biotechs are no longer pursuing cutting-edge technologies, who will focus on potentially groundbreaking but high-risk long-term projects?

Biotech industry insiders have long believed that technology will save the world and that the drug revolution will succeed — this is the general outlook of the industry, even if it takes longer and requires more capital than expected. The foundation of this industry over the past 30 years has been built on such promises. Investors, based on this belief, have poured in more than 300 billion US dollars over three decades.

But this may be a wishful thinking.

When we delve into the direct participants in this industry, including Biotech companies, Big Pharma companies, non-profit laboratories, universities, investors, and customers; the systems connecting these direct participants, including capital market systems, intellectual property protection systems, etc.; and the regulations maintaining the operation of these systems, we find that these participants and systems function well in other high-tech fields but are unable to address the fundamental challenges faced in drug development.

The birth of the science business was marked by the establishment of the first biotech company, Genentech, in 1976. The company was co-founded by young venture capitalist Robert Swanson and Professor Herbert Boyer from the University of California, San Francisco, with the aim of using recombinant DNA technology to develop drugs.

Genentech not only demonstrated that biotechnology can be used to develop drugs but also pioneered a model of monetizing intellectual property, which has significantly shaped today's biotech industry.

This model consists of three interrelated elements:

• Universities transfer technology to the private sector by creating new companies rather than selling technology to existing companies;

  
  

• Investors, scientists, universities, venture capital, and public equity markets jointly bear the risks of innovation;

  
  

• A specialized market for knowledge trading: In this market, young Biotech companies provide intellectual property to established companies in exchange for financial support.

  
  

The Rise of Intellectual Property Asset Monetization Systems Intertwined with High Hopes for Biotechnology

Biotechnology is considered to be on the verge of creating a large number of profitable new drugs. Industry advocates argue that small, specialized biotech companies have a comparative advantage over bureaucratic, vertically integrated pharmaceutical giants in developing new drugs. Therefore, large pharmaceutical companies should focus on marketing and leave innovative R&D to flexible Biotech companies. Even some executives of large pharmaceutical companies seem to believe this, as they actively seek alliances with Biotech companies.

In 1978, Genentech reached an agreement with Eli Lilly, under which, in return for the rights to produce and sell recombinant insulin, Eli Lilly would fund the development of the product and pay Genentech royalties. This agreement broke down a major barrier for new companies entering the pharmaceutical industry: the development of a drug typically takes a long time and involves huge costs. It was also the first time a biotech company outsourced a patented R&D project to a for-profit enterprise. Since then, almost every new biotech company has established at least one contractual relationship with an established pharmaceutical or chemical company, and most have formed several such relationships.

Before the emergence of biotechnology, science and commerce operated largely separately. Basic scientific research was the responsibility of universities, government laboratories, and non-profit institutions; commercializing basic science—using it to develop products and services to extract its value—was the domain of for-profit companies. Biotechnology fused the two, creating a science-business model that other industries, such as software and semiconductors, had already adopted.

The structure of the biotechnology industry looks very similar to other high-tech industries such as software and semiconductors. It includes university-incubated startups focused on R&D; venture capital and public equity markets; and a market for know-how. These are key to understanding the rapid development of Silicon Valley's high-tech industries.However, biotechnology is fundamentally different from other high-tech industries in the following three aspects:

• Profound and persistent uncertainty, coupled with very limited human knowledge of biological systems and their mechanisms of action, makes drug development a high-risk endeavor;

  
  

• The process of drug development cannot be simply divided into several stages, which means that all involved disciplines must collaborate very closely.

  
  

• A lot of knowledge in biotechnology is intuitive, which makes collective learning extremely difficult.

  
  

Specifically, the safety and efficacy of a candidate drug can only be determined through a long process of trial and error. Despite significant advances in genetics and molecular biology over the past few decades, scientists still find it difficult to predict how a particular new molecule will behave in the human body. After years of effort, the most likely outcome for an innovative drug project remains failure. To date, biotechnology has actually increased the uncertainty in drug development, requiring scientists to engage in more trial and error.

Profound and sustained uncertainty translates into high, long-term risks. At first glance, the biotech company's intellectual property asset monetization system appears to manage such risks, but closer examination reveals hidden flaws in the system.

Venture capital firms have a horizon of about three years for a specific investment, far shorter than the 10 to 12 years most companies need to bring their first drug to market. Moreover, because they need to diversify risk, even the largest funds cannot invest huge amounts in any single startup. According to data from the National Venture Capital Association (NVCA), the average investment in biotech companies is approximately $3 million, with an average cap of $20 million—far lower than the $800 million to $1 billion typically required to develop a new drug.

Biotech companies rely on public equity markets and strategic alliances to bridge the gap. However, this brings other issues.

The system of public stock markets was not designed specifically to address the challenges faced by R&D companies, but the majority of IPOs are from R&D companies—companies whose valuations cannot be based on earnings as most of them do not have earnings. Their value depends almost entirely on the R&D projects they are undertaking. However, trying to evaluate them based on projects with significant technological and commercial uncertainties is nearly impossible.

The problem is obvious: insufficient information. For general intangible assets, especially R&D projects, there are no clear disclosure and valuation standards. Generally Accepted Accounting Principles (GAAP) typically do not require companies to disclose their R&D projects, although biotechnology and pharmaceutical companies must disclose information about the status of their R&D pipelines, the requirements are vague. Without sufficient information, even the most sophisticated valuation techniques cannot function effectively.

Do large pharmaceutical companies that enter into cooperation agreements with biotech companies have the knowledge to evaluate the technical and commercial prospects of projects? For instance, does Merck, Novartis, or Eli Lilly's willingness to invest in a biotech company’s project indicate that the company has good development prospects? Not necessarily. Large pharmaceutical companies often form alliances in areas where they lack expertise. Moreover, in many cases, they spend heavily on collaborations but gain little in return.

This is a flaw in the monetization system of intellectual property assets.

Due to the emergence of the biotechnology industry, the toolkit for drug development has become larger and more diversified. In the mid-1970s, it was dominated by the single discipline of medicinal chemistry. Today, it includes molecular biology, cell biology, genetics, bioinformatics, computational chemistry, protein chemistry, combinatorial chemistry, genetic engineering, and more.

These new tools are opening up new opportunities, but each one only reveals a part of a very complex puzzle.Therefore, the integration of multidisciplinary fields is more important than ever before. Scientists of different types need to repeatedly exchange large amounts of information. In other words, they must collaborate in a highly integrated manner.

There are two basic approaches to achieving integration. One is vertical integration, where a company owns all the necessary pieces—this is what traditional pharmaceutical enterprises tend to do. The other relies on a network of markets, in which independent experts come together through alliances for licensing and collaboration—this is how small Biotechs operate.

The core of most Biotech companies is composed of highly focused teams of scientists, forming many isolated islands of expertise. The success or failure of the biotechnology industry heavily relies on market mechanisms that can connect these isolated knowledge hubs. However, there are signs that the current market mechanism fails to address issues regarding the flow of information and the comprehensive solutions required for developing new drugs.

For example, for the intellectual property (IP) market to function efficiently, rights need to be clearly defined and well-protected. In the software and semiconductor industries, strong IP protection mechanisms are commonly in place. A piece of software code is a fairly unique entity that can be legally protected, and theft is relatively easy to detect. In the biotechnology field, however, the IP system is far more complex and ambiguous. People often do not know clearly what can be patented and what cannot. Moreover, the most valuable IP is typically not a specific molecule but rather the data, understanding, and insights about how that molecule behaves, what it can do, its potential issues, and its possible development. Patenting this kind of knowledge may be much more difficult.

The fuzzy and complex intellectual property system has brought about two problems: one is that it makes owners very hesitant to share knowledge, and the other is that it provides fertile ground for contract disputes.These two points have caused endless headaches for Biotech companies, with lawsuits between former partners and collaborators being quite common. In fact, the Genentech and Eli Lilly recombinant insulin deal, which in many ways served as an industry template, ultimately ended up in a legal dispute. After jointly developing recombinant human erythropoietin (a synthetic protein that stimulates the body to produce red blood cells), Amgen and Johnson & Johnson engaged in a fierce legal battle over the division of market rights. A few years later, they were again in disagreement over whether a new version of the drug was an entirely new product or a modification of the original.

Another major obstacle to sharing information is that much of the knowledge critical to drug development cannot be adequately described in writing, as the causal principles behind the technology or know-how are unclear, which is common in emerging fields.

But for the science-based biotechnology industry, the importance of learning cannot be overstated.Both the biotechnology and general pharmaceutical R&D sectors face profound and enduring uncertainty, which means that new hypotheses and discoveries must be continuously evaluated, choices and trade-offs must be made, and these decisions must be made amidst the fog of limited knowledge and experience.

Drug discovery remains an art that relies on judgment, instinct, and experience. A scientist's personal understanding of a molecule, a biological target for attacking a disease, or the mechanism of action of a drug within the body cannot be precisely summarized. Experimental data is subject to various interpretations and perspectives. Therefore, the long-term sharing of experiences is crucial, and the breadth of such sharing is highly important. Solving problems requires collective intelligence.

Unfortunately, the biotechnology industry has not organized itself to learn and improve from these experiences. The monetization of intellectual property is still responsible for this. The market for proprietary technology hinders companies from forming long-term learning relationships. The lack of clearly defined intellectual property is one issue; another is that cooperative partnerships tend to be short-term. Too often, the priority is closing a deal rather than building the capacity for long-term collaboration. As a result, most collaborations remain at arm’s length and are fairly short-lived.

According to research by Josh Lerner of Harvard Business School and Ulrike Malmendier of Stanford Business School, a typical collaboration agreement has a term shorter than four years, far less than the time required to develop a drug. Moreover, collaborations tend to focus on achieving specific, short-term milestones; if a milestone is missed, the collaboration may be terminated.

In summary, the barriers to consolidation and learning in this industry are substantial.Considering these barriers, it is not surprising that the biotechnology industry encounters issues with R&D productivity.

Unless there is a significant change in the mechanism, biotechnology will be unable to fulfill its tremendous potential in the field of drug development.

• More Vertical Integration

  
  

Vertical integration is crucial for the future of the pharmaceutical industry, especially in the pursuit of the most innovative drug development sector, where it is particularly useful. Large pharmaceutical companies have the ability to become integrators, but they need to make changes—most large pharmaceutical firms have established isolated islands of expertise within their own organizations, a practice that has serious issues and may also explain their low R&D productivity. They need new internal structures, systems, and mechanisms to connect specialized technical departments with functional units.

• Fewer, tighter, and longer-term collaborations

  
  

Given the breadth and speed of technological change, even the largest pharmaceutical companies cannot encompass every aspect of new drug development, and they need the help of universities and smaller specialized biotech companies. However, the way they collaborate needs to change.

For highly innovative projects, more meaningful partnerships are those that occur less frequently but are deeper in nature. Instead of signing 40 agreements in a year, a pharmaceutical company would do better to engage in five or six projects at a time, with durations lasting 5 to 10 years and broader scopes of collaboration. For instance, the collaboration should not focus on a single molecule but rather on a specific therapeutic area or indication. Such partnerships may lead to greater sharing of proprietary information, deeper joint learning, and more productive investments.

• Fewer and Fewer Independent Biotech Companies

  
  

Small, startup Biotech companies are an important part of the biotechnology industry. However, the number of independently listed companies will significantly decrease. The publicly held model will only be suitable for profitable companies, allowing investors to assess their prospects; according to existing disclosure principles, pure R&D enterprises do not fall within the realm of public equity.

• Quasi-public corporations

  
  

A possible alternative for a publicly listed company is a quasi-public company. The shares of such companies are publicly traded, but a large corporation with a long-term strategic interest in the success of this biotech company holds a majority stake. This relationship would provide a company with stronger oversight than a typical public company, a longer-term perspective, and more guaranteed capital investment, all of which are crucial for drug development.

It will also allow the company to operate largely independently and offer stock options and other incentives to attract and retain entrepreneurs. Genentech, majority-owned by Roche, is one of the few examples. Genentech has consistently been profitable; its R&D programs rank among the most productive in the industry; despite rapid growth, it continues to maintain an entrepreneurial and science-driven culture.

• New Priorities for Universities

  
  

Universities should focus primarily on maximizing their contributions to the scientific community rather than on maximizing their licensing revenue and equity returns.

When the relevant technology is a broadly applicable tool-type technology with many potential (but uncertain) application pathways, "open" licensing of upstream discoveries should be widely provided under reasonable economic terms. If recombinant DNA, monoclonal antibodies, and other fundamental genetic engineering technologies had been licensed exclusively to a single company, the development of biotechnology would have been significantly slowed.

When a specific technology downstream has its value decrease as the opportunities for use increase, and it requires certain capabilities to fully exploit, it becomes necessary to grant exclusive licenses to existing companies. For example, if a novel cancer therapy is licensed to a company experienced in developing cancer drugs and skilled in designing and managing clinical trials, the therapy might be utilized more thoroughly. However, if the therapy is also licensed to its competitors, the company may be reluctant to invest in its development.

• More interdisciplinary academic research and more translational research

  
  

In commercial drug development, the knowledge base is fragmented into highly specialized niches, which is a major obstacle to integration. Some universities have established interdisciplinary research institutes over the past decade, bringing together scientists from fields such as biology, chemistry, mathematics, computer science, physics, engineering, and medicine. This collaboration represents a step in the right direction.

Historically, the problem with translational research has been that the National Institutes of Health (NIH) and other government agencies funding basic research consider it applied science, while private venture capitalists see it as too risky and long-term. Moreover, conducting translational research requires investment in knowledge assets, such as novel animal models, which may be difficult to commercialize or even protect.

Translational research can be funded in two ways: The first is to further extend the scope of government funding downstream. The second is through more private funding, such as the largest pharmaceutical companies increasing their support for university translational research; venture philanthropy organizations can also play a role. These organizations are often privately funded non-profit entities focused on advancing treatments for specific diseases, such as the Bill & Melinda Gates Foundation, which is primarily used for AIDS and infectious disease research in developing countries. The fundraising and management methods of these organizations are similar to those of traditional for-profit venture capitalists, but with several significant differences: they have a longer time horizon, and their goal is to make a difference in treatment rather than generate profits for limited partners within three to five years.

In summary, after 30 years of experimentation, it is clear that biotechnology is a high-tech industry, but it is also very different from other high-tech industries such as nanotechnology and semiconductors. We need a different approach to understanding the biotechnology industry, one that meets both scientific and commercial needs. Only then can it fulfill its promise to revolutionize drug discovery, overcome the most challenging diseases, and create enormous economic wealth.

References:

Can Science Be a Business?: Lessons from Biotech, Gary P. Pisano，Harvard Business Review, 2006.10