My last post provided an introduction and something of a road map for my upcoming posts. The objective of this post is to make sure we all have a common understanding of the terms “investment strategy”, “business model” and “value chain”, and how these terms are related. This will help us in future discussions about how biotech firms typically approach investment strategy and in discussing how it could be done better.
A firm’s investment strategy outlines “what”, “when” and “how” it will interact with its value chain to create value for shareholders. These decisions are embodied in its business model.
What is a “value chain”?
Michael Porter introduced the concept of the value chain in his book Competitive Advantage (published in 1985 and now a pivotal reference in the academic literature on strategy), using the term to describe all the activities a firm performs and how those activities interact. He said a firm’s value chain is embedded in a larger stream of activities, called the value system. This figure shows a typical value chain for the development of a drug.
Often, in the process of biotech drug development, firms will take up one or a number of the activities required to take a product from discovery to market.
Although Porter originally coined the phrase value system to describe this entire process, most people typically refer to it as the value chain. So I am going to use that term to cover activities carried out upstream, downstream and in parallel to the activities undertaken with a given firm.
The value chain is composed of a matrix of supply chain relationships along the drug discovery process. Only a small handful of biotech companies are engaged in the full value chain, from research and development through to marketing. The vast majority of biotech firms exploit a small or specialised niche.
The pharmaceutical value chain is characterized by two quite different focuses. The first is the business of scientific innovation – discovering a lead drug candidate then taking it through various stages of screening and preclinical testing, and eventually phase I and II human trials. A phase II trial is usually aimed at achieving a clinical proof of concept. The second focus is on commercialisation, which involves gathering information required by regulators and customers and communicating it to them. These activities occur during phase III clinical trials, the regulatory approval processes, marketing and selling, and any phase IV post-marketing studies.
Whilst the value chain outlines the major stages involved in getting a drug from concept to market, it does not indicate how multiple parties may interact with the value chain around any one (or multiple) stage. The vast majority of biotech firms either contract or collaborate for access to a wide variety of skills and complementary assets (such as manufacturing, sales and marketing infrastructure and distribution) that are vital to the development and commercialisation of their own innovation, or they provide know-how and services that other firms are reliant on.
The commercialisation strategy of a biotech involves the decisions it makes about “what”, “when” and “how” it will interact with its value chain. (Investment strategy also includes decisions around other parameters that can be particularly important in some biotech companies e.g. “where” to situate a company, “who” strategic partners are, “whom” strategic shareholders are, etc. But we’ll consider that at a later point.)
“What” describes the final product or service that the firm offers. For a pharmaceutical company this includes the formulation, presentation and therapeutic indications for a drug. “When” describes the point in the value chain that a firm decides to earn a return on its innovation. For example a firm may decide to sell or license a drug candidate soon after its discovery, or after preclinical testing or after phase I, II or III clinical trials. “How” refers to the revenue model through which value flows back to the company. Examples of revenue transaction mechanisms include direct physical product sales, licensing of technology for royalty payments, sale of technology and outright sale of the entire firm. All these strategic choices are summarised in a firm’s business model.
Arguably each firm should aim to insert
their product, service or intellectual property into the value chain at the point that will maximize value creation for its shareholders. Full integration is not an option for most biotech firms due to a limitation in financial and human resources. So a commercialisation strategy needs to evaluate the costs, rewards and risks of participating further down the value chain, or enabling the firm to control more of the product development, manufacturing and marketing activities. To do this it is helpful to have a good understanding of what factors drive a company to commercialise (earn a return) in the “market for ideas” vs. the “market for products”. That is coming up in my next post!