CHICAGO – There has been increasing concern that current models for financing innovation in biopharma – and by extension medical technology in general – are “broken”.

A recent Economist article (“From bench to bedside” on Nov. 4, 2006) summarizes some of these difficulties and highlights a new book (“Science Business”) coming out on Tuesday by Harvard Business School professor Gary Pisano. This is a hot topic and one that this column has referenced several times in recent postings.

In summary, there are two models driving innovation in the life sciences.

Large pharmaceutical companies have traditionally developed and financed sizeable, in-house research labs. However, the paucity of new drugs in the pipeline have not generated sufficient fruit from these efforts and a number of factors (generic drugs, extensive red tape, inertia and a focus on blockbusters) have been blamed for this innovation drought.

To an extent, this is not unexpected as it has long been understood that there is generally an inverse relationship between the size of an organization and its capacity for innovation. The public certainly seems to have realized this as pharmaceutical share prices grossly underperformed over the past five years.

The Dow Jones U.S. pharmaceutical index has gone down approximately 20 percent while during the same period the overall Dow Jones index has gone up about 25 percent.

Industrial behemoth IBM realized this during the late 1970s, and in order to break out of the mainframe mode, the company implemented a radical innovation: a new business model. Big Blue sent 12 engineers to Boca Raton, gave them near-complete independence, and within a year, they created the first personal computer using entirely off-the-shelf components.

From this, the modern PC was born. While nothing new was invented, it was a radical innovation that nearly brought down its parent company. New business models or their consequences can be as disruptive (and even more so) than individual technologies.

In general terms, the other model for innovation revolves around venture capital firms and smaller biotech companies. While on the surface the creation of small and nimble biotech firms would seem to solve the problem of size, there are two major problems that have stymied real business development around this model.

The first – identified in the Economist article – is that venture capital has “shriveled up” in America. That begs this question: How could venture funding be so sparse in a capital market that is relatively awash in capital? In reality, most of that capital is going to private equity and hedge funds that have “exit windows” substantially shorter than most venture capital expectations for the life sciences.

To put money down and not expect an exit for at least five years is not a game that most investors – even far-thinking venture capitalists – are willing to play. To be fair, the venture capital model works extraordinarily well in the software and IT markets. Silicon Valley is rightly envied and envied models are often emulated.

Time to market (Microsoft’s new Vista operating system notwithstanding) for software products is nearly an order of magnitude faster than most conventional drug development. It is therefore unfair to assume that the VC model will work for biopharma.

In my mind, there is a second reason – especially recently – why venture capital has been relatively unsuccessful in the biopharma market. Companies that successfully raise money are ones that have a very simple and focused business model that fits well with the three-minute elevator pitch. For example: “Here’s drug ‘X’ that cures ‘Y’ disease.” Enough said.

Moreover, to make their venture patrons happy, these companies do not deviate from that focus. “Focus, focus, focus” is the mantra.

I remember being at a private equity conference where a company had a great new drug formulation. I commented to their CEO that there were other applications of their technology that could be brought to market even faster and to even larger markets. The CEO told me that they need to “focus” and their venture backers would not look kindly upon any “diversions”.

So much for “nimble” biotech companies.

While these are of course generalizations, I suspect this paradigm is not uncommon especially since the concept of investment diversification takes place at the level of the VC firm rather than the level of the portfolio company. That is a shame as it imposes a dangerous level of bureaucracy on small firms.

So what are the business models of the future? The Economist article points out a few trends. There is a new crop of venture firms that “focus” on new areas.

As well, the Milken Institute has also entered the fray and disease-focused charities (such as the Cure Alzheimer’s Fund) are bringing to bear their resources to finance innovation. In previous columns, I have highlighted some important trends that lend insight into what may be some of the business models of the future. In particular:

1. The importance of partnerships.
2. The ascendancy of innovation over invention.
3. The rise of convergent medical technologies.

In this regard, the example of the IBM PC is quite relevant. Partnerships (for example with Microsoft and other providers) helped to break out of the Big Blue box.

The IBM team did not invent. It innovated. The PC revolution was a completely disruptive development that came out of a convergence of technologies rather than something entirely new. It all happened very fast (in less than a year).

Given these trends (for the traditionalists out there, there is the powerful example of the IBM PC from the early 1980s), new business models in biopharma will need to accommodate partnerships, innovation and convergence.

The inability for big box pharma or little box venture capital to integrate these elements into the very core of their development is what I believe ails the industry. Though I have some ideas for business models that may cut through this impasse, we’ll leave that for a later column.