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Financing innovation: the venture lab

Gary Dushnitsky ventures inside the lab exploring how entrepreneurial companies understand sources of venture capital

By Gary Dushnitsky . 11 June 2012

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The pharmaceutical industry is the testing ground for a major shift in how entrepreneurial companies understand and utilise different sources of venture capital. Gary Dushnitsky ventures inside the lab.


The escape route from our challenging times is innovation. We need to be more innovative, create new industries, develop new products and services, and increase productivity. Innovation will create that much needed employment and growth.


Innovation requires the investment of talent, time and money. Over the last decade, my research has looked at the financing of innovation. When I started working in this space, the common answer was that independent venture capitalists stimulate technological innovation. Nowadays, we see an influx of new investor types entering the venture capital market, including corporate investors, venture philanthropists, and others. Documenting the implications for innovation is the subject of my recent work.


Pharma chameleon


Real alternatives and complements to independent venture capital are now emerging. Consider the pharmaceutical industry. A 2012 survey of CEOs of biotechnology ventures in the US found that three times as many pointed to corporate investors as a likely source for funding in the year to come. The figure was previously only 10 per cent.


The shift has to do with fundamental changes to R&D in the industry. In pharmaceuticals the time and money necessary to develop a new drug has increased substantially, as costs of sophisticated infrastructure and talent rise, as do regulatory demands. Independent VC funds have traditionally invested in a biotechnology company and known that, with a fair commercial wind, they would be able to liquidate that investment successfully a few years down the road. In pharmaceuticals, that time period will now be 10 years and require substantial investment along the way, thus eroding returns significantly.


This explains why, broadly speaking, VCs perceive fewer opportunities in pharmaceuticals, leading to a dearth of VC in that industry. Of course, it creates opportunities for other forms of entrepreneurial finance to step in. Indeed, over the recent years, the pharmaceutical industry has witnessed corporate venture capital and venture philanthropy growing in significance.


Venturing corporately


The rise of corporate venture capital (CVC) -investment by large corporations in entrepreneurial ventures - has been especially driven by the relative stagnation in VC fundings, but also by several other factors.


The reality is that nowadays many corporations - especially in pharma - have more capital in their treasuries. They have cash to put into play. In addition, incumbent pharmaceuticals have a great many resources — state-of-the-art laboratories; deep knowledge of regulatory systems; global distribution channels; insights and experience in how to position and sell a drug; and others. By leveraging these corporate resources, corporations can catapult the growth of young biotechnology companies.


In some of my past research, I have found that, in the pharma industry, CVC-investing corporations outperform their industry peers both in term of overall financial indicators (namely, market-to-book values) as well as in terms of innovation outputs (namely, generating patents).


It is therefore not a surprise that corporate venture capital is well established in the pharmaceutical industry. Johnson & Johnson’s venture arm JJDC was set up in 1973; Roche has its Roche Venture Fund which goes back to the early 1990s and has a 500 million Swiss franc ($500 million) fund; and SR One, the venture arm of GlaxoSmithKline (and originally of SmithKline) was established in 1985. Eli Lilly span out its venture capital arm Lilly Ventures in 2009 with a $200 million investment fund. It invests in biotechnology, medical technology and healthcare IT.


A growing number of other pharma companies are setting up their own venture units. For example, Teva Pharmaceuticals, the world’s largest generic drug company, has recently officially launched a venture fund.


The way forward


In the face of these shifts in biotechnology financing, there is one thing we don’t know: are alternative forms of funding more or less conducive to driving innovation? Specifically, do corporate-backed biotech companies produce the same type and quantity of innovation as VC-backed ones?


In recent research, with Dr. Alvarez-Garrido, we put together a database of almost 600 US-based biotechnology companies founded between 1990 and 2003. Around a third of these received funding from corporate venture capitalists. We looked at the innovation outputs of these biotechnology companies. In particular, we investigated the scientific publications generated, as well as the patenting activity of those biotech start-ups.


We found that CVC-backed start-ups do no worse than venture capital-backed start-ups. Indeed, their innovation track-record is at least as good as venture-backed start-ups, or better. Interestingly, we found that in the area of fundamental scientific research - the kind done by eminent scientists who found or lead many current biotech start-ups - CVC-backed start-ups deliver superior innovation. They publish more academic work, and they do that irrespectively of whether or not the corporation targets the same broad market, niche or therapeutic area.


When it comes to applied research - patentable research that has more immediate commercial use - we observe an interesting pattern. Compared to VC-backed start-ups, biotechnology companies exhibit superior patenting output when they target an area not currently served by their corporate investor. This superior performance is eroded when the biotech company operates in the same industry niche as the corporation: in those cases CVC - and VC — backed start-ups exhibit similar levels of applied research.


The evidence suggests that alternative forms of funding are associated with unique innovation trajectories. Specifically, the findings allude to a novel pattern of division of labour in the world of pharmaceuticals. Start-ups which operate in areas where their corporate investor already operates may be more focused on basic research, and likely work with and through the sponsoring corporation to monetise their work.


The shifting landscape


Make no mistake, the market for venture capital continues to be an important means of driving innovation. In the US, venture capitalists invested $28.4 billion in 3,673 deals in 2011, an increase of 22 per cent in dollars and a 4 per cent rise in deals over the prior year, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association.


The aforementioned findings, however, uncover a changing awareness of the process of drug development and commercialisation. In the past, this was interpreted as a sprint: as VC-backed companies developed an innovative drug, commercialised it, and experienced lucrative exits. It was a world where the first to cross the line won, and won big.


Now, what we have is more akin to a relay, where the baton is passed from one runner to the next. Different players and investors can and do work together along the drug discovery process. Accordingly, it is important to understand that the biggest bang for the investment buck may no longer be in taking something from A to Z, but rather to identify where there is a particular market failure in terms of the availability of funding for innovative biotech companies. In some cases, university research takes that development from point A to point D, while corporate venture capitalists - and other investors - support biotech companies at later stages.


Seen this way, it is clear that we can no longer have one solution for funding entrepreneurial innovation. Because the development of pharmaceuticals is a highly complex ecosystem, there is a need for different forms of entrepreneurial finance, and those investors should be encouraged to work in concert.


Of course, the pharmaceutical industry is not unique in having start-ups driving both basic and applied research. The energy sector, as well as the food industry, is critical for our economy and for our lives, and has many of the same characteristics. Interestingly, the number of corporate venture capitalists in the energy sector has ballooned over the last decade, and they are also now important players in the food industry. One way or another, in all of these industries the future of venture funding is unlikely to ever be the same again.


(This article was first published in Business Strategy Review, Volume 23 Issue 2)

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