With dwindling cash reserves and publicmarkets increasingly hostile, stopgap merg-ers or acquisitions appear likely for manybiotechnology ventures. But consolidation isnot the only option open to companies, par-ticularly if they plan their corporate partner-ships creatively. A sober look at the biotech-nology sector in recent years reveals that,instead of betting on just one card, successfulcompanies make deals to exploit every aspectof the potential value of their intellectualproperty. More often than not, these dealsleverage know-how to gain financialresources without sacrificing independence.Indeed, rather than being swallowed up bybig pharma, biotechnology companies canbargain relationships that not only reap richrewards, but also maintain their indepen-dence. And, instead of succumbing to thedevastating downward “hockey stick” cashflow profile (a characteristic of firms that relysolely on successful product development),company expertise can be exploited to gener-ate cash flow curves that rise briskly to earlybreak-even and also provide ample returns inthe long term. In the following article, wedescribe the different types of deals that canbe struck and discuss how to achieve theright balance between these deals to assuresteady access to financial resources.

From boom to bust?Biotechnology firms, once the darlings of theinvestment community, today find them-selves lodged uncomfortably between a rockand a hard place when it comes to accessingthe financial resources necessary to grow.Times are very different from when investors,dazzled by the stunning success of companieslike Amgen (Thousand Oaks, CA) andGenentech (S. San Francisco, CA), werehappy to up the ante and wait for the returnsto pour in. Successes have proved to be rareexceptions, and the high failure rate of

biotechnology start-ups in general has leftthe financial community wary of investment.According to Jeffrey Swarz, a biotechnologyanalyst at Credit Suisse First Boston (NewYork, NY), “There are only a handful, lessthan a dozen, biotech companies that havetruly succeeded in the last 12 years. And ifyou consider that, over that time, there werewell over 300 biotech companies, then theoverall success rate has been about 4% in thissector.”

The hype surrounding the field in the1980s—driven by overblown promises ofquick and efficient cures for all the major dis-eases—has long since given way to a moreskeptical attitude of the investment commu-nity to biotechnology. As a result, investorshave tended to bank on a few large compa-nies, which continue to rise to the top and getricher while the rest are poor and gettingpoorer. Cash reserves of these latter not-yet-profitable companies have, on average, dwin-dled to just enough to get through a year, andin 1998 the entire sector experienced a netloss of US $4.1 billion1. Consequently, mostbiotechnology companies now face a tougherstruggle than ever to obtain funding and sur-vive long enough to bring a product success-fully to market.

Seeking both improved cash flow and newinfusions of capital, many companies arecombining in the hope that their jointknowledge and financial resources can keep

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them afloat. But the combinations, even ifstrategically appropriate, do not always havethe desired results. For example, inNovember 1998, Trega Biosciences (SanDiego, CA), a combinatorial chemistry com-pany, acquired NaviCyte (Sparks, NV), ahigh-throughput screening, computer mod-eling, and simulation company. The combi-nation enabled Trega to integrate productsand services spanning the entire drug discov-ery process, and to accelerate its molecularmodeling efforts.

Notwithstanding these synergies, theTrega–NaviCyte acquisition, like many otherbiotechnology mergers and acquisitions(M&A), has had little or no positive impacton the market capitalization of the partner-ing companies. Why? Perhaps because M&Aactivities are often considered only as a lastresort, after both partners are in a weakenedstate. Few investors are likely to believe thattwo sinking vessels can become an agile bat-tleship just by linking up. Similarly, acquisi-tion by a pharmaceutical company may sig-nal the beginning of the end of a biotechnol-ogy enterprise through a loss of the autono-my, flexibility, and entrepreneurial upsidethat are needed to attract the top talent.

Mix-and-match deal makingCreative deal making between biotechnologyand pharmaceutical companies may be anattractive alternative to M&A for addressing

FEATURE

Deal making for growthBy creating a balanced portfolio of deals in different areas, companies can increase thelikelihood of growing cash flow and achieving their long-term goals.

Carsten Geyer, Regina A. Hodits, Friedemann Janus, Josef M. E. Leiter, Alexander Moscho, and Hendrik Rosenboom

Carsten Geyer was an intern, FriedemannJanus, Regina A. Hodits, HendrikRosenboom, and Alexander Moscho areassociates, and Josef M. E. Leiter is a principalat McKinsey New Venture,Prinzregentenstrabe 22, Munich, Germany(alexander_moscho@mckinsey.com;josef_leiter@mckinsey.com).

Table 1. Types of deals that can be struck between biotechnology companies and their partners.

Deal type Description of deal Example (date)

Product Focuses on a lead compound Gensia deal that has some proven effect in with Pfizer (5/96)animal studies

Pre-product Focuses on aspects that are Pharmacopeia further from the final drug such deals withas insights into disease Bayer (02/96), mechanism or drug formulation Novartis (10/95),

Schering Plough (12/94), and Zeneca (01/97)

Information and Focuses on a particular Medarex deals technology technology platform with Schering

(02/98), Bristol Myers Squibb (06/98), and Novartis (11/98)

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the financing shortfall. By definition, suchdeals should be mutually beneficial.Biotechnology companies have a businesssystem based on basic research and discov-ery, and often lack direct access to end cus-tomers. Consequently, nearly all of their rev-enues initially have to come from licensingdeals with pharmaceutical companies. Insuch deals, pharma not only provides vitalfunding, but also other capabilities, such aslead refinement, clinical development, regu-latory expertise, and sales and marketingknow-how. For its part, big pharma needsthe knowledge and technologies thatbiotechnology start-ups provide to keep itsdrug development pipelines filled.

On the whole, licensing deals tend tofocus exclusively on a particular aspect ofthe drug development process, a factor thatbio-technology companies should considerand exploit to reap the greatest rewards fromtheir knowledge assets. Our analyses showthat a key factor in the success of biotechnol-ogy companies is the creation of balancedportfolios comprising three types of licens-ing deals: product deals, pre-product deals,and information and technology (I&T)deals (see Table 1).

Product deals are structured around leadcompounds that have some proven effect,for example, in animal models. Theselicensing deals begin in the preclinical phaseand involve the codevelopment of com-pounds through the clinical phases, mostoften including agreements on the commer-cialization of the drug. An example is the1996 agreement between Gensia (Irvine,CA) and Pfizer (Sandwich, UK) to developand market Gensia’s adenosine-regulatingagent for treating pain.

Pre-product deals are structured aroundsmaller contributions to the final drug and

thereby focus onearlier parts of thevalue chain. Dealcontent is eitherdisease insight(proven by doc-umened mecha-nisms or validatedtargets, and chem-i c a l / b i o l o g i c a llibraries) or drugformulation anddelivery systems.P h a r m a c o p e i a(Princeton, NJ),for example, haslicensed collec-tions of rationallydesigned small-molecule com-pounds to Bayer( L e v e r k u s e n ,G e r m a n y ) ,

Novartis (Basel), Schering-Plough(Madison, NJ), and Zeneca (London).

I&T deals are structured aroundgenomics data and research tools, orscreening tools and assays. They allow acompany to barter its proprietary technol-ogy either exclusively to one partner ornonexclusively. Medarex (Annandale, NJ),for example, has at least 10 ongoing part-nerhips for its transgenic mouse system,which creates high-affinity, fully humanantibodies.

In addition to these three kinds of deals,biotechnology companies commonly enterinto agreements on cell cultures or infor-mation technology services. These arm’s-length transactions are distinguished fromthe deals listed above because they areessentially just service contracts, providingno royalties. Although they can be impor-tant in providing short-term revenues,

management should rather focus on get-ting the more significant financing thatemanates from product, pre-product, andI&T deals.

Taken together, the three major types ofdeals provide four sources of funding: royal-ties, that is, a percentage of ex-factory sales;milestones paid on achieving defined targetsin the development process; down paymentswhen signing a deal; and fees for service, gen-erally based on full-time equivalent costs ofthe scientists conducting the ongoing researchefforts. The size and timing of payments differsignificantly for product, pre-product, andI&T deals, resulting in distinctive cash flowprofiles for each deal type (Fig. 1).

Because each of the deal types describedabove has a different cash flow profile,biotechnology companies need all three toensure a steady inflow of financial resources.In other words, smart deal making aims tocreate a portfolio of deals that balances riskand return for the entire company. Toaccomplish this, executives need to under-stand both the promises and the pitfalls ofeach type of deal.

Long-term profit from product dealsThe dream of nearly everyone who launchesa biotechnology start-up is getting the com-pany’s own product on the market and rev-enues in its coffers. A major step in thisdirection is the participation in end-cus-tomer sales through royalties. Product dealsoffer the highest royalties by far. Our analysisof biotechnology companies shows that asuccessful product deal typically holds thepotential for cumulative cash flows of overUS $500 million.

One of today’s most successful product-driven biotech companies is BiochemPharma (Laval, PQ, Canada), established in1986. Originator of reverse transcriptaseinhibitor 3TC, the best-selling HIV drug on

Deal diversification fosters growth

Millennium Pharmaceuticals is a good example of a company whose deal-making strategyshould enable it to evolve into a bona fide pharma competitor. Founded on the basis of abroad technology base, Millennium is now progressing from I&T deals only, to pre-productand product deals, thereby achieving the steady funding necessary to enable it to grow.

Originally describing itself as a “genomics-driven science company” (missionstatement, April 1998), last year Millennium completed a deal with Bayer that may prove tobe the turning point toward future growth. Under the terms of the deal, Millennium not onlywill deliver validated targets, but will now receive back from Bayer any target that Bayerdecides not to use within a certain time frame. Millennium may thus take refinedtargets/leads generated from Bayers’ high-throughput robot screening process anddevelop them further into marketable drugs, either through new deals or through its newlyestablished development affiliates.

The deal has secured for Millennium not only a stronger product platform for futuregrowth, but also a more stable financial footing. When investors learned of the deal, theyresponded immediately and enthusiastically, lifting Millennium’s market cap to an all-timehigh of more than US $1.3 billion in February of 1999.

Figure 1. Biotechnology companies have to strive for the correct dealportfolio. Individual characteristics of the three deal types shown (i.e.,differences in amount and timing of royalties, milestones, and downpayments) result in distinctive cash flow profiles.

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the market, Biochem Pharma now has a mar-ket cap of over US $3 billion, driven mainly byroyalty income from Glaxo Wellcome’s salesof 3TC. The 1990 product deal with Glaxoresulted in a 1995 launch of 3TC and totalsales of US $824 million in 1998, resulting inroyalty streams of more than US $100 millionfor the biotechnology company.

The success of companies like BiochemPharma camouflages some of the drawbacksof product deals. First, companies actuallyearn royalty payments only if the compoundssuccessfully pass the clinical phases and theapproval process. Thus, there is a risk that thecompany will never receive any payments.Consequently, companies that focus only onproduct deals have a much higher probabilityof failure. Second, a drug candidate can bethe subject of only one deal per market(defined geographically or by therapeuticarea). Taken together, of roughly 300 prod-uct-driven start-ups formed in the early1980s, only 10 had turned themselves intosuccessful companies by 1993.

Finally, because of changes in theinvestor landscape, the story of BiochemPharma could probably not be repeatedtoday. It took the company 10 years to breakeven on its income statement (apart fromone-time effects in 1992). To stay afloat, thecompany was repeatedly able to place fol-low-on offerings on the equity markets.Today, investors prefer to pour their cashinto the high-flying Internet and informa-tion technology companies, which offermuch quicker returns—at least from post-initial public offering (IPO) valuations.

Because of the limitations associated withproduct deals, biotechnology executives needto tide their companies over the rough patcheswith pre-product deals and deals based on I&T.

Pre-product deals—an early steppingstoneIn a pre-product deal (e.g., granting access toa chemical library, delivering validated tar-gets, or formulating drugs), initial down pay-ments, milestone payments, and ongoingresearch fees provide the major source ofremuneration. Our analysis indicates that asuccessful pre-product deal can earn a com-pany an average of US $50 million. Althoughsuch deals leave less upside potential for theseller, the same asset, such as a library, can besold more than once because the library canbe used in several different contexts.

Last year’s alliance between MillenniumPharmaceuticals (Cambridge, MA) andBayer is a good example of how a pre-prod-uct deal can serve as an important steppingstone for a biotechnology company. Thealliance will provide Millennium with US$465 million in total funding for the supplyof 225 new drug targets that have been iden-tified as relevant to cardiovascular diseases,cancer, osteoporosis, and four other thera-peutic areas. The up-front payment alone hasled Millennium to end the 1998 business yearin the black with more than US $160 millionin cash on hand (see “Deal diversificationfosters growth”).

I&T deals top up the coffersI&T deals earn lower up-front payments than

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pre-product and product deals because of thelower additional value creation and limitedupside potential associated with these deals.On the other hand, they have the advantagethat the same technology can be sold manytimes. Our analysis of I&T deals showed thatcumulative payments were on average aboutUS $10 million per successful deal.

Thus, I&T deals can be an ongoingsource of extra funds; however, they do notgenerate enough to sustain a businessbecause rapid commoditization quicklyerodes margins. For instance, in genomics,the price for sequencing a base has dropped85% in three years, from two dollars (in1996) to thirty cents (in 1999), a good illus-tration of the impact of accelerating techno-logical life cycles.

A good example is Genome Therapeutics(Waltham, MA; formerly known asCollaborative Research), which originallyfocused on dealing with genomic data andwas unable to generate any profits at allfrom 1990 to 1995. Only after shifting fromI&T deals to pre-product deals in 1995 wasit able to realize small net profits on up-front payments. The effect on market capi-talization was immediate: investors’ hopesfor more upside potential drove GenomeTherapeutics’ valuation from about US $30million in early 1995 to around US $170million by year-end 1995.

Although I&T deals may be attractivein the short term, companies that focus onthem exclusively may find they havedeclining margins because of the short“half-life” of the technology licensed. The

FEATURE

NucleoKnowledge: A case history*

NucleoKnowledge is a public biotechnology company thatapproached us for advice on how to establish a broad platform ofdeals that fully exploited its intellectual and technologicalresources. In many ways, this company was suffering from an"embarrassment of riches." On the basis of its solid proprietarytechnology platform, it had seven products in development, inseven different therapeutic areas, with five different partners.Unfortunately, not one of these products was expected togenerate a net income contribution until 2002, whereas the 200scientists employed in state-of-the-art research were burningcash at the rate of US $18 million a year. With annual revenues ataround US $3 million, management contacted McKinsey when itrealized that cash reserves would last only another 18 monthsand that the company would face difficulties raising another US$15 million in cash.

The royalties from NucleoKnowledge’s existing product dealswere rather low at 10%, despite the substantial investments that thecompany would have to make in preclinical and clinicaldevelopment. Ten minor I&T deals with academia and otherbiotechnology companies were expected to generate net returns ofonly about US $1 million per year. Subtracting fixed costs, break-even was expected around 2004. Before then, cash reserves wouldhave long since run out. Because investors had already lost money,follow-on offerings were not a realistic option.

We advised NucleoKnowledge to set up a value-creatingportfolio by taking the following steps: First, focus product dealswith a few strategic partners and in core therapeutic areas (i.e., threedeals in two areas with two strategic partners). Second, license drugdevelopment outside the core area at a pre-product stage (i.e.,contract out seven deals). And third, develop standard packages oftechnology deals to be marketed primarily to academia.

After a tough process of renegotiating some deals, we believeNucleoKnowledge will have a balanced and manageable dealportfolio. Seven pre-product deals will be contracted out, turningknow-how outside the company's strategic focus into near-termcash, while retaining some upside potential. The number ofbiotechnology partners for the I&T deals is also being reduced. Newdeals with academia will contribute short-term income.

The intensified management focus on core competencies shouldalso lead to better and faster decision making. The reduced numberof interfaces with fewer deal partners should lower the risk of frictionand management failures, and fewer, more profitable product dealsshould provide a bigger share of the upside rewards. Finally, byconstructing a full spectrum of deals, overall risk is reducedsignificantly. Currently, break-even is expected by year-end 2001,which can be expected to raise the company's valuationsignificantly.

*All names and figures changed to protect company confidentiality.

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rapid pace of technological developmentmeans that, while I&T deals can provide anice supplement to revenues, they cannotbe relied on as a sole source of funding.Only a stronger revenue base will providethe breathing room required to developunique products with the upside potentialthat investors seek.

Creating a strong deal portfolioRecognizing the necessity of deal making,but the risks associated with limiting deal-making activities to a single deal type,biotechnology companies should attemptto create a balanced deal portfolio. Thisincludes the evaluation of all research pro-jects for their deal-making potential, forexample, for a product development tolicense out the underlying technologies andpre-products. The benefits of this “smart”deal making, with a company-specific set ofproduct, pre-product, and I&T deals, areearlier positive net cash flows from up-front and milestone payments, as well aspreservation of long-term upside potentialfrom royalties on sales. Another attractivefinancial consequence of smart deal makingis the dramatic increase it causes to thecompany’s net present value. This, togetherwith the perceived lower uncertainty of the

business, is directly rewarded by investorswith higher stock prices.

By taking a hard look at their assets andtheir partnerships to create a balanced port-folio of deals, biotechnology executives canminimize risk for themselves and theirinvestors. Companies will benefit fromfirmer financial footing and renewedinvestor confidence. In turn, investors willbenefit from secure financial returns. Andpharma companies will benefit from theknowledge that comes onstream earlier inthe process of drug development.

There are, of course, some pitfalls asso-ciated with companies’ proliferating thenumber of deals in which they engage. Themost common pitfall for biotechnologycompanies after broadening their deal-making activities is the risk of beingtrapped by increasing management com-plexity. Especially when making pre-prod-uct or I&T deals, companies can get caughtup in complex, hard-to-manage deal“webs” as a result of doing business oppor-tunistically with anyone who comes along.The solution is for executives to understandand focus on the core competencies of theirown companies, while leveraging the corecompetencies of a select number of dealpartners (see “NucleoKnowledge: A casehistory”).

When assessing their own potential fordeal making, many companies may bepleasantly surprised by the many ways opento them to realize the value of their businessplatform. Several are already in a positionto diversify and balance their portfolios ofdeals, thereby securing their financial posi-tion and improving their standing withinvestors.

1. Recombinant Capital (1999) http://www.recap.com-/mainweb.nsf

The benefits of this “smart”deal making, with a compa-ny-specific set of product,pre-product, and I&T deals,are earlier positive net cashflows from up-front andmilestone payments, aswell as preservation oflong-term upside potentialfrom royalties on sales.

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