The Memorial Day holiday is a paradox – both solemn and joyous.  It honors those who have fallen in military service to their country. With fluttering flags at gravestones and taps in the air, it is the most solemn of holidays.  It unofficially starts the summer season. With sparkling weather framing joyous graduates, family picnics, the Indianapolis 500 and baseball pennant races, the holiday holds its own festive note as well.

I don’t think anyone has figured out how to greet people after the holiday. It doesn’t quite sound appropriate to say: “Did you enjoy the weekend?” It sounds overly somber and presumptuous to say: “Did you have a reflective weekend?” This seems to strike the right tone: “I hope you had a restful holiday weekend.”

I wish it were restful for me as I spent at least part of the weekend thinking about the topic for today’s column. It addresses another paradox – the “innovation gap” – which is a term originally coined by Mary Good (the former undersecretary for technology in the U.S. Department of Commerce) about the biopharma and medical technology industries.  One solace to a less-than-restful weekend was the realization that this innovation gap problem, which has vexed many over the past decade or so, will certainly not be solved over a holiday (particularly one spent with family and friends at picnics and other events).

What is the paradox of the innovation gap?

In an era in which the potential for truly revolutionary medical breakthroughs has never been greater, the realization of such potential appears to fall far short of its promise. While fundamental discoveries such as genomics, molecular medicine and related R&D spending grow exponentially, the number of novel drugs and products reaching the market continues to decline. While some call it the sparse pipeline problem, that is only one manifestation (the tail end) of the innovation gap.

A few definitions are helpful. This is according to the National Institute of Standards & Technology (NIST), which has published an excellent study on the situation:

“Invention” [is] shorthand for a commercially promising product or service idea based on new science or technology that is protectable (though not necessarily by patents or copyrights).

“Innovation” [refers to] the successful entry of a new science- or technology-based product into a particular market.

The innovation gap represents the inability to take fundamental inventions at the level of the university research lab or an entrepreneur’s initial idea into at least the preliminary stages of commercial development. Roughly speaking, there are two underlying causes for the innovation gap: one financial and the other operational.

The financial reason concerns a relative lack of funding for the phase between invention and innovation. The operational reason relates to organizational, managerial and technical factors that tend to impede the leap from invention to innovation. While the two factors are certainly related to each other – one can think of it like the chicken or the egg issue – it is useful to address each one separately.

The Gap Financing Problem

After 1995, the overall proportion of seed-stage deals (then about 16 percent) fell dramatically (4.54 percent in 2006), according to the recent MoneyTree survey. The survey outlines total venture capital invested, seed-stage deals and the percentage of seed money to total money. Indeed, most innovation gap financing comes from angel investors, corporations and government rather than venture capital firms. This financing problem has been noted by many university technology transfer experts. “There are absolutely tremendous technology opportunities coming out of the university,” said Michael Cleare, executive director of science and technology ventures at Columbia University. “We need more commitment and mechanisms to tap into that intellectual capital.”

Multiple factors have led to the gap financing problem. These include:

1.      A world awash in capital. One would think that more capital would mean more funding. The opposite has actually happened. Lower interest rates have resulted in a decisive shift toward debt-based financing.

As I commented earlier on the private equity boom, it makes no sense to apply debt financing to innovation projects for which there is no immediate prospect of revenue to service that debt. Every newspaper splash about the latest mega deal means a lot less money is deployed toward earlier-stage projects.

One corollary to the debt-leveraged private equity boom is the investor preference for acquisitions rather than equity plays. On Monday night, Charlie Rose spoke with Warren Buffet in which Buffet outlined the Berkshire Hathaway investment strategy as being decisively focused on acquisitions.

These days, investor sentiment (which often likes to follow Buffet) is decidedly biased toward acquisitions. This really only makes sense when those acquisition targets are revenue-generating concerns.

2.      Mega deals. While the headlines are dominated by multibillion-dollar mega deals, there certainly are smaller private equity and venture firms out there. Nonetheless, even the smallest of venture funds have progressively gotten larger in the deals they are able to do.

Due diligence (and all the other attendant aspects of doing a deal) takes time and money. As many entrepreneurs know, most venture funds will not even consider deals that are less than $10 million in size. There is also a correlation between size of the deal and the maturity of the underlying business.

Early stage deals typically are not large.

3.      Inefficient risk assessment. As technology gets more complex and as the cost of evaluating risk becomes greater, it is a challenge to properly evaluate risk for early stage companies and appropriately allocate equity, value and consequent investment.

While inefficient markets harbor the possibility of great returns, capital typically stays away and at the very least exacts an onerous risk premium on fledging projects.

The gap financing problem is a serious matter that results in projects lingering on in university labs. Ideas that do make the leap often do so after at least a year of pitching venture funds. The exhaustion and equity hit at the end of the tunnel is so typically great that the all-important motivational spark becomes subtly if not actually extinguished.

The Operational Innovation Gap

An earlier column on life sciences business models highlighted how certain structural aspects of early stage biotech and medical tech companies lay the seeds for failure or at the very least a reluctance by investors to commit financing.

One of the most important factors behind the innovation gap is the concept that venture capital invests more in management than necessarily the underlying ideas. There is much truth to the venture folklore that a good management team can extract gold from dirt while there are legions of examples in which bad management have doomed otherwise promising ideas to failure. The corollary of this is that any project intending to leap past the innovation gap must gather about it an absolutely world-class management team.

Assembling top-notch management has three implications:

1.      It reduces the execution risk for the project and emboldens investors who would otherwise not commit to the project.

2.      It serves as a proxy to due diligence such that a VC firm gains additional confidence from the fact that some leading individuals are also behind the project.

3.      It costs money. By definition, there is only a finite pool of experienced management.

The last point is critical. It’s a major reason why most projects simply cannot move beyond the simple invention stage. While a great management team is highly desirable (and a bad management team certainly is abhorred), not all ideas traversing the innovation gap require a phalanx of grey-haired executives on the team.

I am reminded of the climactic scene in the 1980s Michael Douglas film “Wall Street” in which corporate raider Gordon Gekko struts about at the annual meeting of Teldar Paper. There is a paradox among paradoxes. While investors demand top-notch management, such management runs the risk of extracting more cost than value and scaring away the very same investors. A full corporate structure accompanying top-flight management also requires substantial overhead. Though the ascendancy of the virtual company has been heralded, systems and processes still accompany every corporate structure that wraps itself around a fledging idea.

The increasing prevalence of life sciences incubators and science parks has helped to mitigate some of this operational overhead. Even so, many of these incubators suffer from one fundamental problem: They have a strong disincentive to have their rent-paying start-up tenants move out. This mutual dependency or “weaning” problem has the paradoxical effect (even if psychological) of potentially slowing down development within these incubators.

In his book entitled “Science Business,” Gary Pisano of the Harvard Business School has pointed out how operational paradigms that may have been appropriate to software technology development have likely encumbered early stage life sciences companies. I have argued previously that holding companies specializing in life sciences interim management may represent one possibility of more efficiently allocating human capital among multiple projects. Combining this with an upgraded incubator model that addresses the weaning problem would result in what I would term a “life sciences accelerator”.

Memorial Day Redux

Most chemical reactions involve a sequence of steps from initial reactants to final products. It is a well-known law of kinetics that the overall rate of a reaction is determined by the slowest step in that process. The innovation gap is more than just a sad litany of promising ideas snuffed out and laid to rest. Instead, it’s the rate-limiting step along the arduous journey of bringing life-saving ideas from initial concept to actual patient benefit. There are many obstacles along the path from the bench to bedside. While it is difficult to quantify in strict kinetic terms a process that involves multiple parallel, diverging and/or converging paths, I would say the major barrier is the innovation gap.

While solving this problem would not necessarily prevent all ideas from suffering an untimely death, it would at least allow more of them to reach their full potential. The tragedy of a lost idea is nowhere near that of the ultimate sacrifice, but as Memorial Day fades into summer, let us reflect upon those who have fallen and look to the future.

Ogan Gurel, MD MPhil
gurel@aesisgroup.com
http://blog.aesisgroup.com/

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