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1042-2587-01-262Copyright 2003 byBaylor University
E T P Anne Evans: Assessment
of a Biotechnology
Anne G. Evans
Nikhil P. Varaiya
This case describes Anne Evans’ search for a market opportunity in the biotechnology
industry, and examines the feasibility of establishing a new venture to exploit this oppor-
tunity. The drug development process in the biopharmaceutical industry spans three cri-
tical phases: pharmaceutical discovery, pharmaceutical development, and product
marketing. The drug development process is a very capital-intensive process with expen-
ditures averaging $800 million per drug and with very high failure rates—only one out of
5,000 compounds that emerge from discovery and preclinical testing will make it into the
market. The drug development process therefore contributes to very high cash burn rates
and corporate failures in the biotechnology industry.
eing intimately aware of the reality and economics of drug development, Anne was
intrigued and excited by the possibility of establishing an intermediary in the pharma-ceutical discovery phase of the drug development process. Such an intermediary desig-nated as a biotechnology services investment firm (BSIF) would bring together providersof discovery testing capabilities and biotechs that would be key users of such criticallyneeded capabilities. Anne believed that the BSIF would succeed by enabling biotechs—and subsequently the much larger pharmaceutical organizations—to significantly enhancethe efficiency of the drug development process. Her MBA thesis examined the feasibil-ity of establishing a BSIF. While Anne was confident about the conceptual analysis under-lying the feasibility of establishing a BSIF, she pondered what action(s) to pursue at thisjuncture. Was she passionate about the venture to overcome the entrepreneurial strugglesthat she anticipated would inevitably follow the launch of her venture?
It was November of 2000 and Anne Evans had just been informed, in confidence, that
the small biotechnology organization (biotech) she had joined less than six months priorwas unlikely to remain as a going concern, in its current form, beyond first quarter 2001. She was advised that fixed costs would have to be drastically reduced and that itwould be wise to initiate a search for a new position. The news was not unexpected, sincethe MBA she had completed that same year had enabled her to read the “writing on the
Please send all correspondence to: Nikhil Varaiya, Department of Finance, San Diego State University, 5500 Campanile Drive, San Diego, CA 92182-8236. email: Nikhil.Varaiya@sdsu.edu
walls” in the corporate financials. The situation was certainly not unique to the industry,since few biotechs had positive cash flow from operations, so when cash from externalsources dried up, the organizations generally withered and died. She knew this all toowell—not just from reading business periodicals or comforting laid off industry col-leagues, but from personal experience—having been laid off roughly two years prior.
The question she kept asking herself was simply, “so now what?” Join the manage-
ment team of yet another biotech and watch it burn through its cash as it tried to beat theodds and bring a product to market? At least her husband and family would know betterthan to suggest that she simply abandon her ten years experience in the biotech and phar-maceutical industry, fall back on her doctorate in veterinary medicine, and retreat to thefiscal stability that a practice in veterinary medicine would offer. The latter was as safean out to her current predicament as it was dull and entirely out of keeping with the inter-ests that had driven her back, midlife, to participate in the executive MBA program atSan Diego State University.
Anne found herself contemplating the thesis that had culminated in her MBA
program. Her business experience spanned the critical phases of drug development: phar-maceutical discovery, pharmaceutical development, and product marketing. Being inti-mately acquainted with the process, Anne was intrigued by the possibility of establishingan intermediary in the discovery phase of the pharmaceutical development process. Suchan intermediary designated, a biotechnology services investment firm (BSIF) would bringtogether providers of discovery testing capabilities and biotechs that critically neededsuch capabilities. Anne believed that a BSIF could succeed by enabling biotechs—andpotentially the much larger pharmaceutical organizations—to significantly enhance theefficiency of drug development. Her MBA thesis examined the feasibility of establishinga BSIF. As she recalled and reflected on her thesis Anne said to herself, “this may rep-resent my opportunity—my opportunity to succeed as an entrepreneur and to reinventthe business of biotechnology!”
Anne Evans’ Background
Anne G. Evans had earned a doctorate in veterinary medicine in her early twenties,
seeking that goal because of her love for animals and passion for science. The latter droveher to advance that degree with post-doctoral training in comparative veterinary-humanmedicine and with a focus on dermatology, allergy, and immunology. She obtained spe-cialty board certification in veterinary dermatology in the mid ’80s and opened a refer-ral practice devoted exclusively to the treatment of dermatologic and immunologicdiseases of large and small animals. The practice was sold in the late ’80s at a profit sothat she could accept what she envisioned as a more challenging academic position as anassistant professor of veterinary dermatology at a prestigious veterinary school, beinginvolved with teaching, clinics, and research. Still, the position failed to bring her careersatisfaction, with the focus on veterinary medicine preventing her from using the fullscope of her training. She turned to human pharmaceutical development.
For most of the ’90s Anne held positions of increasing responsibility that dealt with
business strategy, multinational licensing, development of drugs, biologics, and medicaldevices that were intended for diagnosis and treatment of human disease. Subsequent tojoining the management team of a San Diego biotech startup in 1997, she became acutelyaware that her skills in business management were lacking and that obtaining an MBAwhile continuing her work was the most efficient solution. In August of 1998 she beganan executive MBA program. However, by late 1998 the biotech’s cash was running low,
a third round of financing fell short of corporate and product development needs, and theCEO resigned. Anne left shortly thereafter to embark on a career as an independent con-sultant predominantly serving the local biotech community, although also addressingalternative health and fitness products and services in the scope of her work. Through theremainder of the ‘90s and into 2000 she watched as biotech after biotech burned throughtheir cash, experienced product failures well into clinical development, fell out of favorwith the investment community, laid off double digit percentages of their personnel, andultimately failed as going concerns. The biotech industry’s corporate and product fail-ures drove her to look for answers and were the springboard for the topic of her MBAthesis.
Nearing the completion of her MBA, she accepted a full time position as executive
director of corporate business development for another San Diego biotech. She knew thatthe organization’s potential for long-term profitability was tenuous, at best, however theposition offered some new and interesting challenges that were worth the risk. Shrink-ing market capitalization, declining cash flow, and investor dissatisfaction led to the sit-uation she faced on this day. Once again, it was time to move on in her career.
The Biotechnology and Pharmaceuticals Industries
Collectively, the biotechnology and pharmaceutical industries are generally referred
to as the biopharmaceutical industry. Their products include drugs, pharmaceuticals, andbiopharmaceuticals with these terms frequently used interchangeably.
Unlike the pharmaceutical industry that has been in existence since the late nine-
teenth century, creating multinational corporate giants such as Merck, Johnson &Johnson, and Pfizer, the biotechnology industry is a fledgling that only began to gainrecognition in the ’80s. Although the two industries generate products that target similarmarkets (i.e., diagnosis and treatment of disease) the differences and relationshipsbetween them merit discussion in order to understand why one exhibits substantial cashreserves and profitability, while the other struggles with negative cash flows and layoffs.
The pharmaceutical industry and its organizations (Large Pharma) are mature and
could be characterized as an oligopoly. The industry leaders are multinationals currentlyundergoing consolidation and with heavy reliance on “cash cow” products with revenuesexceeding $1 billion in annual sales and with high margins to sustain their profitability.
As an example, Schering-Plough’s allergy medication, Claritin, generates $3 billion inannual sales. Large Pharma employ hundreds of thousands of people worldwide and arevertically integrated with operations spanning the stages from discovery research throughdevelopment to global marketing and sales. The corporate weaknesses inherent and per-vasive in the pharmaceutical industry are in discovery research; because of its size andassociated bureaucracy, it is slow to foresee market needs, adapt to market change, andexercise innovation.1
In contrast, the biotech industry comprised numerous, mostly small organizations.
Each one typically employed fewer than 100 people and a staff of fewer than ten employ-ees was not uncommon. Most biotechs had not brought a product to market; positive cashflows from operations were rare. Instead biotechs generated cash from their investors(angels, then venture capitalists), licensing fees from large pharmaceutical organizations,
1. Harris, G. & Adams, C. (2001). Delayed Reaction: Drug Manufacturers Step Up Legal Attacks That Slow Generics—That’s One Reason It Takes FDA Longer to Approve Knock-Offs Than Brands—The‘Metabolite Defense.’ Wall Street Journal,
and proceeds of IPOs (initial public offerings). Some biotechs eventually were acquiredby Large Pharma (e.g., Agouron Corporation’s acquisition by Warner Lambert, itself lateracquired by Pfizer) or faded into oblivion along with their dwindling cash flow; the latteroutcome was by far the more common. The corporate strengths of biotechs were in sharpcontrast to those of Large Pharma. Biotechs offered innovation—that is, discoveryresearch—but consistently failed to make it profitable owing to their heavy investmentin personnel and laboratory facilities prior to generating revenue. Anne considered thebiotech industry in her locale—San Diego, California—and could recall only one
biotechover the past five years that had attained profitability through successful product com-mercialization.2 She searched the literature to validate this rather cynical perspective onthe biotech industry and found that “. . . biotech [had] one of the lowest success rates ofany area of pharmaceutical R&D, according to data analyzed from Pharmaprojects
andits sister publication, R&D Time-Lines
. . . . A biotech drug entering development histor-ically has had only a 7 percent chance of reaching the market.3”
The Drug Development Process
Figure 1 provides an overview of the drug development process. Bringing a phar-
maceutical product to market began with a discovery
typified by the research armof research and development (R&D) that generated and screened hundreds to thousandsof compounds for potential therapeutic activity. Those compounds with potentialadvanced into a development
phase, typified by (1) optimization of the structure of theactive ingredient (i.e., drug substance) and formulation (i.e., drug product), (2) preclini-cal (i.e., in vitro4 and animal) testing, and (3) clinical (i.e., human) testing.5
According to the Tufts Center for the Study of Drug Development, it takes on average
15 years for a new drug to move from the discovery phase, into preclinical testing, throughclinical trials, through approval by the U.S. regulatory authority, the Food and Drug Administration (FDA), and into the market. A November 2001 Tufts Center for the Studyof Drug Development report indicated that the average cost of developing a single newdrug exceeded $800 million. Of the average $800 million estimated cost of developing anew drug, about two-thirds is expended in the postdiscovery phase, and one-third isexpended in the discovery phase.6 Exhibit 1 describes the stages and timeline correspond-ing to the key milestones of the drug development process in the United States. The searchfor the next (blockbuster) drug is fraught with substantial risk. Retrospective data analy-sis performed by Tufts suggests that for every 5,000 compounds that emerge from dis-covery and preclinical testing, only about five compounds perform well enough to advanceinto human clinical testing—and only one of these five will make it into the market.
In the past drugs targeted treatment of symptoms rather than cures of
diseases (e.g., the pain, inflammation, and swelling of arthritis). The advent of modern
2. San Diego–based Agouron Corporation’s launch of Viracept.
3. “Biotech Marches on Despite Low Success Rates and Faltering Investment.” PRNewswire,
June 10, 2002,Richmond, England.
4. In vitro testing is testing not
performed on living organisms.
5. This section is based on (1) Robbins-Roth, C. (2000). From Alchemy to IPO: The Business of Biotech-nology,
Cambridge, MA: Perseus Publishing.; and (2) Standard & Poor’s 2001 Industry Surveys
for theBiotechnology and Pharmaceuticals sectors of the Healthcare Industry.
6. Mathieu, M.P. (ed.). (1999). R&D Spending: Pharmaceuticals. In M.P. Mathieu (ed.), Parexel’s Phar-maceutical R&D Statistical Sourcebook 1999,
There is overlap of the individual components of the PharmaceuticalDevelopment Phase—e.g., certain “preclinical” testing is conducted subsequentto initiation of clinical trials and certain aspects of clinical trials continuepostmarketing.
The Drug Development Process: What Happens and When
Pharmaceutical Research and Manufacturing Association.
biotechnology brought forth new research methods (e.g., molecular biology, cell biology,assay development, and combinatorial chemistry) that probed the cellular function and deciphered the causes of diseases. These new tools enabled researchers to discover
specific disease-causing “targets” for drug treatment. In fact, biotech researchers havebecome so adept at the discovery stage that most Large Pharmas devote up to 50 percentof their R&D budgets to partnering with and supporting the research of selected biotechs.
This stage involves a sequence of in vitro and animal studies
intended to demonstrate sufficient safety and efficacy with the drug to initiate and support
human testing. Three to four years of preclinical study may be necessary to obtain the
information required by regulatory authorities, such as the FDA. Preclinical testing con-
tinues in parallel with human testing for much of the development phase.
Phase I Clinical Trials.
Studies here are designed primarily to look at safety in normal
human subjects, and to study how the drug is taken and metabolized by the human body.
The objective is to ensure that the drug is safe, and to design the most rational dosing
regimen (e.g., once or twice daily; oral or injectable administration) for the trials to
Phase II Clinical Trials.
Studies here are designed to provide more information about
how the drug is processed in humans, to begin providing information about effectiveness
in patients, and to continue to gather data on its safety. These studies allow companies
to understand more thoroughly how their drug works with respect to dose, treatment
regimen, and target patient population. Generally, Phase II trials involve a larger popu-
lation of subjects and a lengthier test period than Phase I.
Phase III Clinical Trials.
The role of these trials (also called pivotal trials) is to gener-
ate information that will lead the FDA and/or non-U.S. regulatory agencies to permit the
company to market its new drug. The FDA has estimated that out of every 20 drugs enter-
ing clinical testing, on average, 13 or 14 will successfully complete Phase I with only
one or two surviving the rigor of Phase III trials.
As noted previously the cost and time incurred to complete regulatory requirements
associated with drug development are substantial—despite the recent FDA Guidance forFast Track Drug Development Programs. The latter addresses expedited development and review for only
those drugs intended to treat serious or life-threatening conditions andthat demonstrate the potential to address unmet medical needs. Consistent with this FDAGuidance, in early 1996 several new breakthrough protease inhibitors for the treatment ofHIV and AIDS were approved only a few months after their applications were filed.
However, the majority of drugs offering tremendous market potential (e.g., treatments ofobesity, hypercholesterolemia, and behavioral disorders) fail to meet “fast track” criteria.
The Market Opportunity
“The single largest challenge facing drug developers—both [Large Pharma] and
[biotechs]—is to contain R&D costs and reduce development times without compromis-ing clinical test design. It’s a tall order”.7 Anne’s experience convinced her that increas-
7. Dr. Kenneth Kaitin, Director, Tufts Center for the Study of Drug Development, News Release, November 30, 2001.
ing the efficiency of the drug development process could significantly enhance the growthand profitability of biotechs. She believed that to do so biotechs must (1) emphasize theuse of pharmaceutical discovery phase screening tests to identify and eliminate flawedproducts prior to investing in their development, and (2) reduce the cost of operations by outsourcing (i.e., contracting) these discovery activities, thereby converting fixed tovariable costs.
Anne thus envisioned the BSIF to be a firm that would be the preemptive service
provider in the discovery phase testing market segment with a mission to reduce productfailure and financial burn rates. This firm would serve as a third party intermediary linkingbiotechs—and potentially Large Pharmas—to outsourced discovery testing capabilities.
For a fee, the BSIF—as an agent rather than the discovery testing service provider—would receive, source, negotiate, execute, and manage a biotech’s “order” to contractwith an existing laboratory or scientist(s) to perform the desired testing.
Size of Potential Market
The size of the discovery phase product testing market segment depends on
1. the magnitude of total R&D expenditures by biotechs on both discovery and devel-
2. the proportion of total R&D expenditures that are directed toward discovery phase
Current Status of Biopharmaceutical Product Discovery
and Development Testing
The cost of bringing a biopharmaceutical product to market is high and continues to
grow. In 1989, the average cost per product was $125 million, climbing to $231 millionin 1993. Pre-tax estimates for 1999 ranged from $500 to $600 million—and increased toover $800 million by 2001. These figures include the cost of research failures occurringin various stages of discovery and development that are judged to be at least as high as$440 million. Development phase delays have been estimated to cost $10 million perweek and a 1994 study found that only 30 percent of drugs introduced to market from1980 to 1984 provided returns exceeding their average after-tax R&D costs.8 Premar-keting product failure rates are high and have a tremendous impact on R&D expendi-tures. Product failures occur at all stages throughout both the discovery and developmentphases. During early-stage discovery activities only one out of every 1,000 to 10,000compounds advances further into R&D. Of these, 50 percent fail during preclinicalstudies and, of the remainder, 80 percent fail during clinical trials.
Not only are nearly two-thirds of R&D costs associated with the second phase of
development, costs are highest for the later of the development phase activities. Forexample, preapproval clinical development accounts for roughly 33 percent of totalproduct R&D expenditures, whereas initial discovery phase evaluations for activitiesaccount for only 10 percent. Thus, the cost of product failure is disproportionately higher
8. Maloff et al. (1997). Maximizing Return on Investment and Minimizing Risk in Partnering with Pre-clinical CROs. Drug Information Journal,
for late-stage failures. Even those products eliminated during preclinical evaluation haveexpended upward of $100 million of R&D funds.
Estimated R&D Expenditures for the Biopharmaceutical
Global R&D spending by Large Pharma was over $40 billion in 1998, and industry
analysts estimated R&D spending to be $50 billion by 2000, implying an annual growthrate of 12 percent, which they expected to continue for at least the next three to five years.
Global R&D spending by biotechs was $9 billion in 1998 and expected to grow at thesame rate forecast as that for Large Pharma. Whereas the pharmaceutical industry devoted10 percent to 20 percent of annual sales to R&D, biotechs typically committed over 50percent of annual sales to R&D expenditures. This reflects in part the large number ofbiotechs with no product sales.
With discovery phase expenditures averaging 35 percent of all R&D expenditures,
industry analysts estimated global discovery phase expenditures at $21.5 billion in theyear 2000; Exhibit 2 provides these estimates for the period 2000–2005. Industry ana-lysts expected that by 2000, 11 percent of global R&D expenditures would be outsourced.
R&D Expenditure Forecasts for the BiopharmaceuticalIndustry (2000–2005)1 (in Billions of U.S. $)
1. Engel, S. A time to outsource: Part 1 of 2. R&D Directions
, 5(8), September 1999.
2. Firn, D. Survey-Life Sciences: Temporary help stretches to long term: Contractresearch organizations. Financial Times
, July 15, 1999.
3. Maloff et al., (1997). Maximizing Return on Investment and Minimizing Risk inPartnering with Preclinical CROs. Drug Information Journal
, 31, 857–863.
4. Pilling, D. (1999). Survey-FT Director: Revolution behind surge in budgets: Pharmaceuticals. Financial Times
, June 25.
1 Developed from the following sources: Engel, 1999; Firn, 1999; Maloff et al., 1997;Pilling, 1999.
2 $50 bn in expenditures by the pharmaceutical industry plus an additional $11.3 bnby the biotech industry.
This shift from in-house to outsourced R&D was expected to continue; the percentageof R&D expenditures outsourced was expected to grow at an annual rate of 20 to 30percent for the period 2000–2005.
Anne Evans estimated that outsourced global discovery phase expenditures would
grow from a base of $2.4 billion in 2000 to $12.7 billion in 2005 if outsourced discov-ery phase expenditures comprised 35 percent of outsourced R&D expenditures. Theseestimates were uncertain, of course, and could be higher if more drug candidates resultedfrom new discovery research technologies emanating from the Human Genome Projectand other aspects of genomics, combinatorial chemistry, high throughput screening, andbioinformatics.
The BSIF Anne Evans had in mind would comprise specialists with requisite skills
in assisting clients to outsource their discovery phase activities. Initially, the BSIF wouldidentify and link biotechs with capable discovery phase testing service providers—andgenerally assist with agreement negotiation and execution. Other services would includeoutsourced research management and outsourced activity analysis or consulting. Servicescould be bundled or offered separately as needed. The BSIF would charge fees for iden-tifying discovery phase test capabilities needed by clients, negotiating agreements with,and executing resulting contracts with discovery phase testing services. Factors thatwould influence BSIF fees were likely to be size of offering/contract, difficulty associ-ated with linking the buyer and seller, the BSIF’s competitive environment, due diligenceeffort required, current market demand and conditions, anticipated expenses or conces-sions, and client-specific demands.
Based on Anne Evans’ experience, discovery phase testing capabilities that could be
outsourced by biotechs would range in cost from $10,000 to $5 million per contract. Afee of 10 percent to 15 percent of a contract’s value was proposed as appropriate com-pensation for BSIF services requiring identification, negotiation, and execution of con-tract discovery phase testing capabilities on behalf of a biotech. The percentage quotedto the client would, however, be dependent on whether all of the services listed abovewere included, as well as other relevant factors. In addition to the fees tied to identify-ing discovery phase testing services, the BSIF would provide a variety of managementand consulting services. As most of these projects were not expected to have clearlylimited needs, clients would be billed a fixed rate fee per hour. Biotech experts’ fees gen-erally ranged from $200–$400 per hour.
To assess the demand for BSIF services and acceptability of the proposed fee struc-
ture, six biotech executives and consultants to biotechs were interviewed by Anne todetermine concept acceptance. The respondents were asked whether they would use thisservice and, if so, what they judged as appropriate costs for services. Anne solicitedfurther comments from the respondents regarding attributes that might be critical to theiruse and cost acceptance of BSIF services. A summary of the information provided to therespondents and their replies are given in Exhibit 3; the replies from the respondents werea combination of verbal and written quotes.
Anne believed that these quotations reflected factors that would be crucial to the
success of her venture. She knew that the BSIF needed to provide high-quality, reliableservice and be responsive to its customers. She also realized that competitors would enterthe market, and was concerned about the possibility of biotechs bypassing her BSIF afterthe initial use of its services.
BSIF Concept Testing—Information Provided to Respondents
To assess the demand for a BSIF’s services and acceptability of the proposed fee structure, six potential customers (i.e., Biotechexecutives and consultants to biotech executives) were questioned regarding concept acceptance. The individuals selected received thefollowing information.
A feasibility study for a Biotechnology Services Investment Firm (BSIF) is being performed and your input, as a potential customer, isrequested to assess the concept’s viability and value. The concept is based upon a perceived need to reduce product failure and financialburn rates and that these objectives could be achieved as follows. (1) Greater emphasis on the use of pharmaceutical discovery phase(i.e., early-stage research) screening tests to identify and eliminate flawed products prior to investing in their development. (2) Reductionof the cost of operations by outsourcing (i.e., contracting) these discovery activities, thereby converting a biotech’s fixed costs to variablecosts. The BSIF would be modeled after the financial industry’s investment banking firms, serving as a third party intermediary who willlink biotechs to pharmaceutical discovery testing outsource capabilities. For a fee, the BSIF will—as an agent rather than as thediscovery testing service provider—receive, source, negotiate, execute and manage a biotech’s “order” to contract an existing laboratoryor appropriate scientist to perform the desired discovery phase research testing.
Your organization has a new chemical entity (NCE), or several related ones, that have the potential to become a blockbuster treatmentfor a previously untreatable condition. However, significantly more proof-of-concept discovery phase studies must be performed toidentify the optimal NCE and gain assurance of its potential before initiating costly, standard regulatory-required development testing ofthe NCE’s structure, formulation, preclinical activity, and clinical performance. One option is to obtain and spend the financial resourcesnecessary to build/expand the organization’s (non-) existing laboratory capabilities (i.e., fixed costs committed to plant, equipment,scientists, and technicians) to perform the studies. An alternative is to employ the BSIF’s services to identify, negotiate, contract, andmanage an existing laboratory/scientist with the expertise to pursue the rather unique and NCE-specific studies on an outsourced basis.
(1) Would you seriously consider using the BSIF’s services as an alternative to performing the research in-house?(2) If so, what is the most that you would be willing to pay the BSIF for its services (e.g., 5 percent of the total cost of the outsourced
contract to the BSIF as a “finder’s fee”? 10 percent? 20 percent?)
(3) Can you offer further comment regarding what attributes might be critical to your decision to use the BSIF initially or on an ongoing
basis, as well as factors that might influence the amount that you would be willing to pay for this service?
Responses were gathered either by e-mail response or telephone conversation. A summary of the responses is provided in the table thatfollows.
• Must be a high-quality, reliable service that is highly
• VP with primary outsourcing responsibility.
responsive (both the BSIF & the outsource) to the
• Historically, has outsourced all development
biotech’s need for frequent test-related information.
• With a biotech employing ~50 full-time
• Consider Ø % fee as contract cost ≠ &/or
• Consider a fixed rate fee per hour for some of the
• Publicly held biotech. Current price per
• No marketed products. One NDA awaiting
• A biotech’s founder is usually a scientist that
• Ex executive (current consultant to CEOs).
wants to perform much of the research. Even so,
• Executive for Large Pharma (>1,000
considerable research must still be outsourced, and
full-time personnel) and mid-size Biotech
the BSIF could add value by ≠ outsource
(>50 full-time personnel). Consultant to
small biotechs (<10 full-time personnel).
• The concept is reasonable, but there will be
• While an executive, generally outsourced
some-to-most development, however little-
• Need to start with several fixed-price service
• After initial use of BSIF, biotechs may bypass it and
try to contract directly with outsource service provider.
• Fees will be based on savings recognized by
biotechs (1) by having BSIF identify & negotiatecontract and (2) manage execution of outsourcedservices.
• Prompt response to a biotech’s needs (both the
BSIF & the outsource) will be critical to success.
• Biotech’s provision of equity to BSIF (in addition
to percentage fee) suggested for the following
reasons. (1) As an incentive to ≠ the BSIF’s
• Existing laboratories (biotech’s & founder’s
commitment to perform in the biotech’s best
academic) perform discovery testing.
interests. (2) Decrease biotech’s cash outflow for
• With a biotech employing £10 full-time
• Privately held biotech. High rate of cash
• Fees biotechs will be willing to pay will depend on
bio/pharmaceutical development for biotech
• Biotechs with Large Pharma backing (e.g.,
agreements providing milestone payments) will
• Has held senior management positions with
only be willing to bear relatively lower BSIF fees.
• Self-financed (i.e., Angel, VC funding) will be
willing to bear relatively higher fees.
• Assumptions: fees do not include equity, and the
service is efficient and controllable [by the biotech].
• A biotech’s commitment to future outsource services
generally reduces initial contract costs by 20–30%.
• Knew of three groups trying to accomplish
• Ex CEO (current consultant to CEOs).
• Consider, instead, having the BSIF in license
from biotechs, perform/outsource the R&D, and
partner the more developed/promising NCEs to
Large Pharma for final development, marketing,
• From biotech employing £10 full-time.
• Privately held. High rate of cash burn.
• No marketed products and none near
• My understanding of outsourcing, as well as
• Ex CFO of biotech fully-owned by Fortune
principles I have used in my own decision-making,
is that you outsource non-critical tasks. This allows
• Prior experience as president and owner of
you to focus on your core business. For biotech
drug discovery, you find the smartest and most
aggressive scientists and hire them to sweat out thenew discoveries and eat and breathe this. Thiswould be a scary thing to outsource.
Organizations) exist is that the companies can layout a very detailed and straightforward program.
Drug discovery is not straightforward in any senseof the word. It is inspired serendipity and luck. Ifthis is farmed out, and the science doesn’t work, theconsultant gets bashed. If it does work, theconsultant is so involved that he or she should begetting equity upside.
1 Questions:(1) Would you seriously consider using the BSIF’s services as an alternative to performing the research in-house?(2) If so, what is the most that you would be willing to pay the BSIF for its services (e.g., 5 percent of the total cost ofthe outsourced contract to the BSIF as a “finder’s fee”? 10 percent? 20 percent?)(3) Can you offer further comment regarding what attributes might be critical to your decision to use the BSIF initiallyor on an ongoing basis, as well as factors that might influence the amount that you would be willing to pay for this service?
Competitive Analysis of BSIF Target Market
Anne Evans’ research failed to identify organizations serving the market segment tar-
geted by the proposed BSIF. She, therefore reasoned that a preemptive first-mover entryby targeting biotechs as initial customers could yield sustainable competitive advantages(see Exhibit 4). Following BSIF market entry Anne had identified two groups of poten-tial entrants based on their assets and competencies: biopharmaceutical contract researchorganizations (CROs) and business management consulting firms (BMCFs). The formerunderstood biotechs’ technical needs and the latter, their management needs.
BSIF Sources of Preemptive Competitive Advantage
Discovery Service Supply• Secure access to discovery test providers.
• Dominate service supply logistics.
Linking and Consulting Service• Secure superior service development personnel (i.e., business plus biotechnical expertise).
• Preempt a position as the most reliable service.
• Become the industry service standard.
Service Systems• Develop process effectively and efficiently linking biotechs with discovery testing providers.
• Expand linking and consulting capabilities to discourage competitors from market entry.
Biotech Customers• Train biotechs in BSIF usage.
• Condition biotech in BSIF name recognition.
• Secure long-term commitments from customers.
• Gain specialized knowledge about targeted Biotech customer needs.
Service Distribution• Occupy offices in prime biotechnology industry locations.
CROs perform contract research testing services with the vast majority offering
development phase testing services. However, some CROs that have provided standard-ized
discovery testing and development
management and consulting services were likelyto be more direct competitors of the BSIF. If these CROs elected to develop customizeddiscovery testing they would reduce biotechs’ need to utilize the BSIF to identify andlink them to such services. Alternatively, CROs that decided to expand into discoverymanagement and consulting could become formidable competitors of the BSIF. CROsjudged as the greatest potential threat to the BSIF were Discovery Partners International,MDS Panlabs, Phoenix International Life Sciences, and Quintiles Transnational. Exhibit5 summarizes Anne’s assessment of the competitive strengths and weaknesses of thesepotential competitors.
BMCFs as potential entrants into the BSIF’s market segment were likely to be a less
significant threat than CROs. BMCFs generally offered corporate finance, process man-agement, strategy, and technology application services spanning multiple product,resource, and service industries including biotechnology. Several large BMCFs providedbiotechnology R&D consulting services including process, strategy, and productivityimprovement. Further expansion into the research (i.e., discovery) consulting componentof their existing R&D services would put BMCFs into direct competition with the BSIF.
However, such a move would require significant investment in additional, highly skilledpersonnel to provide these services. BMCFs Anne recognized as potential threats includedErnst & Young, Deloitte Consulting, and McKinsey & Co. Exhibit 5 provides this strate-gic group’s competitive strengths and weaknesses.
Empirical evidence from studies suggested that the BSIF as a first mover into its
market segment would gain, at least, a short-term advantage in market share. One study(of mature industrial goods businesses) reported that first movers into markets averaged29 percent of market share; early followers 21 percent; and late entrants 15 percent.9
9. Robinson, W. T. (1988). Sources of Market Pioneer Advantages: The Case of Industrial Goods Industries.Journal of Marketing Research,
Key Strengths and Weaknesses of Potential Competitors
Biopharmaceutical Contract Research Organizations (CROs)
• Provider of discovery phase testing services
• Small CRO and early-stage venture.
performed in own labs by full time personnel.
• Ability/willingness to customize test offerings.
• Sensitivity to and focus on the needs of the
• Limited scope of discovery testing capabilities.
BSIF’s target customers and market niche.
• Management team and technical personnel.
• Culture (innovative, adaptive, motivated).
• Primarily a domestic (San Diego) corporation.
• Subsidiary of a major competitor in the CRO
• High volume/low cost structure suggests limited or
inability to customize discovery phase offerings.
• Largest provider of standardized discovery
• Corporate size and organizational structure consistent
with inability to adapt to specific customer needs.
• Significant access to capital.
• Multinational Corporation with name
• Corporate size and organizational structure predisposing
to inability to adapt to specific customer needs.
development phase tests, some standardized and some semi-customized discovery phase
• Significant access to capital.
• Multinational Corporation with name
• Image (development phase service provider).
• Largest provider of development phase testing
• Lack of commitment to providing discovery phase
• Historically inflexible (e.g., organizational structure, to
customer services) suggest inability to adapt to market
Business Management Consulting Firms (BMCFs)
3, 4Ernst & Young
• Limited knowledge of sources of discovery phase
• Current biopharmaceutical customer base dominated by
• Information technology systems applicable to
large bio/pharmaceutical corporations; not small
establishment of database of service providers.
biotechs initially targeted by the BSIF.
• Multinational corporations with name
• Questionable commitment to discovery phase market
1 Discovery Partners International is privately held, thus strengths and weakness are based on Anne Evans’ consulting inter-actions with the organization.
2 Source: Evans, 1999.
3 Sources: Developed from the following World Wide Web sites: and4 Strengths and weakness are provided for the BMCF strategic group as a whole, rather than for individual organizationswithin that group.
Estimated Start-Up Costs (Year 0) (in US $)
Founder & Cofounder (each with Doctorate + MBA)
1,000 sq. ft prime location in “Golden Triangle” (@$25/sq ft/yr)
Information Technology & Communication Set-Up & Support
1 Source: D. Hearst of Cushman Realty, La Jolla, CA. (December 30, 1999).
However, other studies Anne reviewed reported that the failure rate among first moversinto markets is 47 percent, with the five factors identified as critical to success beingvision, persistence, commitment, innovation, and asset leverage.10 These same studiessuggested that the mean market share of surviving pioneers is 10 percent. Exhibits 6through 8 reflect the results of Anne Evans’ financial analysis to assess her proposedBSIF’s operating profitability for the years 2000–2005. The long-term BSIF market shareand profitability (i.e., after the fifth year of operations going forward) depended onwhether both CROs and BMCFs are expected to be early followers into the BSIF’s marketsegment.
Estimates of Long-Term Profitability for Proposed BSIF
The BSIF’s startup costs, which Anne projected at $510,000, included cash outflows
for personnel, offices, information technology and communication, business travel, andpromotion of services. Successful entry and gain of market share could be dependent oninvesting in top professionals and in prime quality office space with high visibility andin close proximity to customers (see Exhibit 6).
Anne’s vision was that the BSIF’s growth strategy would be to compete by differ-
entiating competencies that provided sustainable competitive advantages, resulting incontinued gain of market share subsequent to entry of followers into its market segment.
These differentiating competencies would include premium quality customer service,management that combined biotechnical and business expertise, and market researchcapabilities. Anne was confident that the BSIF’s sources of revenue would be renewable.
Instead of bypassing her BSIF, after initial use as an identifier of outsourced services,biotechs would become repeat BSIF customers because of the cost savings recognized
10. Tellis, G. J. & Golder, P. N. (1996). First to Market, First to Fail? Real Causes of Enduring Market Lead-ership. Sloan Management Review,
BSIF Market Forecast and Growth Strategy, 2000–2005 (in Millions of U.S. $)
1 Year 0 devoted to set-up of initial office (see Exhibit 6 for startup costs); no revenues expected to be generated.
2 Figures derived as 15% fees on forecasts for outsourced global discovery phase expenditures.
3 Total cost of new capacity from preceding year plus 4% annual inflation reinvested in expansion of existing offices.
4 Exhibit 7 provides costs for set up of initial office. Cost of additional offices projected at 075 million plus 4% annualinflation ¥ # of new offices.
5 See narrative discussion under “Competitive Analysis” for market share forecast justification.
6 Revenues = Market Share ¥ Size of Market.
7 Net Income (after tax) derived from estimated 10% Profit Margin ¥ Revenues. See narrative discussion under “Estimates of Long-Term Profitability for Proposed BSIF” for profit margin forecast justification.
Incrmental Free Cash Flows, 2000–2005 (in Millions of U.S. $)
1 Assume credit sales.
2 Pretax operating expense includes depreciation allowances but excludes interest expense and is estimated at 80% of totalrevenues. See narrative discussion of EBIT under “Estimates of Long-Term Profitability for proposed BSIF” for operat-ing expense forecast justification.
3 Tax rate = 30%. See narrative discussion under “Estimates of Long-Term Profitability for proposed BSIF” for operat-ing expense forecast justification.
4 Incremental working capital of $.25 million in Year 0, & thereafter maintained at 20% of the difference between thecurrent and preceding year’s total revenues.
from its contract management services. The first set of customers Anne would target werebiotechs, segmenting them into (1) newly funded startups, and (2) established firms withrestricted cash flows, due to high burn rates. As the BSIF established a proven record inreducing pharmaceutical discovery costs, a second set of customers would be targeted.
This set comprised Large Pharma that although unhampered by cash flow restrictions,faced huge outlays for discovery phase testing and were under constant pressure (fromthe capital markets) to enhance profitability.
Anne intended to retain all earnings for the first five years of operations and use them
to grow the initial office as well as open new offices in geographic hotbeds of the biotech-nology industry. She estimated the cost of each new office at the cost of the first($510,000) plus 4 percent annual inflation. Existing offices would be allocated the costof new office capacity from preceding years plus 4 percent annual inflation for expan-sion. The BSIF’s profit margin was estimated from data Anne obtained on publicly heldCROs that she judged as significant potential competitors (MDS, Phoenix InternationalLife Sciences, and Quintiles Transnational). For 1999 the after-tax profit margins for theseCROs ranged from 5.3 to 7.8 percent. However, Anne knew from her industry experi-ence that each also provided contract testing and therefore was committed to significantlaboratory and associated personnel fixed costs far in excess of what she expected theBSIF to incur. Therefore, she estimated the BSIF’s profit margin at 10 percent. Anne’sforecasts suggested that during the BSIF’s first five years of operation sufficient netincome would be generated to open 12 offices. The growth strategy is detailed in Exhibit 7.
Estimated incremental free cash flows are provided in Exhibit 8. Anne based them
on the following: she would start with $0.25 million for working capital and outlays forthe initial office, and maintain future working capital at 20 percent of the differencebetween the current and preceding year’s total revenues. Anne estimated the BSIF’s earn-ings before interest and taxes (EBIT) from the financials of the CROs noted above. For1999, their EBITs ranged from 7 to 13 percent, with the former figure associated with anorganization that subsequently restructured to cut costs. Due to the BSIF’s anticipatedlower cost of operations, Anne assumed an EBIT rate of 20 percent. The BSIF’s tax rateof 30 percent was selected based on the reported tax rates for these same CROs. HerBSIF’s preliminary valuation based on these revenue and profit projections is providedin Exhibit 9.
Decision Time for Anne Evans
In the course of the last few years Anne had attended numerous presentations in which
venture capitalists and founders of technology startups addressed the requirements forsuccess of entrepreneurial ventures. All agreed that the success of any venture dependedon its ability to generate attractive long-run growth and profitability. The latter in turndepended on the attractiveness of the venture’s market opportunity, and the competitiveposition created by the management team to exploit the venture’s market opportunity.
As Anne reviewed her options after learning she would soon be—once again—
without a job in the biotech industry, she was well aware that she did not want to returnto either veterinary practice or to academia. She realized, as well, that she harbored atwinge of bitterness toward the biotech industry that had now laid her off twice and dealtsimilar blows to valued colleagues. She was extremely confident about her assessmentof the BSIF’s potential as a going concern as well as the possibilities it held to generatepersonal wealth. However, while Anne had no doubts regarding her business analysis
1 Modeled from the following source:Wetzel, W.E. “Venture Capital” (1997). In W.D. Bygrave (ed.), The Portable MBAin Entrepreneurship,
2nd ed., 184–209. John Wiley & Sons, New York.
2 Obtained from growth in Size of Market in Exhibit 7; assumed same for all threescenarios.
3 “Most Likely” Revenue = Exhibit 7 “Total Revenues” for 2005. Best/Worse Case= +/-%10.
4 See narrative discussion of profit margins for related businesses under “Long-TermProfitability.”5 Most young growing companies have a P/E of 15 (Wetzel, 1997), which is used as“Most Likely.”6 Total equity value = revenues ¥ profit margin ¥ P/E.
underlying the feasibility of establishing a BSIF, she pondered what action to pursue atthis juncture. She asked herself, “Is the BSIF what I truly want to dedicate myself to?”Anne recalled some of the comments offered by the executives she had interviewed toidentify BSIF attributes that would be critical to its success (i.e., the BSIF “must be ahigh-quality, reliable service . . .”; it must provide “prompt response to a biotech’s needs”;it must have a “strong commitment to confidentiality”). Wasn’t it interesting, Annethought to herself, that none
of these executives had identified as a critical success factorwhether Anne had a passionate, unrelenting commitment to make this entrepreneurialventure succeed. She knew that the latter was absolutely essential to the BSIF’s successor failure. So there Anne sat. She looked in the mirror and asked herself, “Am I excitedby the prospects of launching this venture and do I have the passion to see it through tosuccess that will sustain me through the entrepreneurial struggles that will inevitablyfollow?”
Methodology Used to Prepare Case
This case is based on a thesis project required in the Executive MBA Program at San
Diego State University (SDSU). For most of the ‘90s Anne Evans held positions ofincreasing responsibility in the biopharmaceutical industry dealing with various aspectsof the drug development process. Anne has identified a potential market opportunity asso-ciated with the drug development process that she hopes to exploit via an entrepreneur-
ial venture. Her MBA project completed in August 2000 examined the feasibility of estab-lishing this venture. Anne Evans’ co-author is Nikhil Varaiya, a professor in the EMBAProgram at SDSU and was Anne’s faculty advisor on her project. Anne Evans is verykeen to have her “process of discovery of an entrepreneurial opportunity” become anintegral part of an instructional case study.
In the fall of 2000 a first draft of the case study was distributed to students in
Professor Varaiya’s graduate entrepreneurial finance course to seek input about the caseand its viability for classroom use. Thereafter, a revised version of the case was used inthe spring of 2001 in his financial management course in the EMBA Program at SDSU.
Additionally, CFOs of two well-known biotechnology firms (which are subsidiaries ofpublicly traded pharmaceutical firms) in San Diego also reviewed the case and providedinsight into the complexity of the drug development process. The present version of thecase reflects graduate student input and Professor Varaiya’s experience from continuinguse of the case with EMBA participants.
Nikhil P. Varaiya is a professor and chairman of the Department of Finance at San Diego State University.
The authors wish to thank Gregg Capella, Alex DeNoble, David Galanti, Larry Gitman, Kent Johnson, DaveOsborn, and Dennis Smith for their insightful comments on earlier versions of this case. We want to espe-cially thank three anonymous reviewers and the case editor, William Sandberg of Entrepreneurship Theoryand Practice
for their comprehensive and insightful comments and suggestions.
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