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Who is minding the Innovation Gap?

I hope you had a restful holiday weekend. The Memorial Day holiday is a paradox. 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.

Unofficially, it starts the summer season and with sparkling weather framing joyous graduates, family picnics, the Indy 500, and heated up 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. “Did you enjoy the weekend” doesn't quite sound appropriate. “Did you have a reflective weekend” sounds overly somber and presumptuous. “I hope you had a restful holiday weekend” seems to me to strike the right tone.

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 - namely the “Innovation Gap” (a term originally coined by Dr. Mary Good, former Undersecretary of Commerce for Technology) facing the biopharma and med-tech industries.

Yes, I had a restful weekend but part of it was spent grappling with the “Innovation Gap” issue and its possible solutions. One solace was the realization that this problem, which has vexed many over the past decade or so, will certainly not be solved in a weekend, particularly one spent with family and friends at picnics and other events.

What is the paradox of the “Innovation Gap?”
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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.

To put it in more concrete terms, while fundamental discoveries such as genomics and molecular medicine and related R&D spending grow exponentially, the number of novel drugs and products reaching the market continues to decline. Some call it the sparse pipeline problem, but that is only one manifestation - the tail end - of the innovation gap.

A few definitions are helpful. According to the National Institute of Standards and Technology (NIST), which has published an excellent study of the situation:

… “invention” [is a] 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, then, 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. The two factors are certainly related to each other (one can call it a “chicken or egg” issue), but it is useful to address each one separately.

The Gap Financing problem

According to the National Venture Capital Associaton and PriceWaterhouse Coopers Money Tree Survey, since 1995 the overall proportion of seed-stage deals as a percentage of total venture capital invested fell dramatically to essentially miniscule numbers; presently it is 4.5 percent. As also highlighted in the NIST report, most innovation gap financing comes from “angel” investors, corporations, and government, not venture capital firms.

This gap-financing problem has been well noted by many university technology transfer experts. “There are absolutely tremendous technology opportunities coming out of the university” notes Dr. Michael Cleare, executive director of the Columbia University Innovation Enterprise, but “we need more commitment and mechanisms to tap into that intellectual capital.”

A confluence of multiple factors have lead to the gap financing problem. These include:

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 towards leveraged (debt-based) financing. As I had 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 that billions less are deployed towards earlier-stage projects. One corollary to the debt-leveraged private equity boom is the investor preference for acquisitions rather than equity plays. Recently, Charlie Rose hosted Warren Buffet for an interview in which Mr. Buffet outlined the Berkshire Hathaway investment strategy as being decisively focused on acquisitions. Investor sentiment these days (which often likes to follow Mr. Buffet) is decidedly biased towards acquisitions which, again, only really make sense when those acquisition targets are revenue-generating concerns.

Mega deals. While the headlines are dominated by multi-billion 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 that they are able to do.

Due diligence (and all the other attendant aspects of deal-making) takes time and money and, 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 are never large.

Inefficient risk assessment. As technology gets more complex and as the cost of evaluating risk becomes greater (especially in the context of no definable revenues and rapidly changing markets), it is a challenge to properly evaluate risk for early-stage companies and hence appropriately allocate equity, value, and consequent investment. Inefficient markets harbor the possibility of great returns but, generally speaking, capital stays away and at the very least exacts an onerous risk premium on fledging projects.

The gap financing problem is a serious matter resulting 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, and often the exhaustion and equity hit at the end of the tunnel is so great that the all-important motivational spark becomes subtly, if not actually, extinguished.

The operational “Innovation Gap”

An earlier article on life sciences business models highlighted how certain structural aspects of early-stage biotech/medtech 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 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 a world-class management team.

Assembling top-notch management has three implications:

• It reduces the execution risk for the project, thus emboldening investors who would otherwise not commit to the project.

• It serves as a proxy (or at least a supplement) to due diligence such that a venture capital firm gains additional confidence from the fact that some leading individuals also are behind the project.

• It costs money, and by definition there is only a finite pool of experienced management to draw upon.

The last point is critical and underlies 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 to be 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 film “Wall Street,” in which the corporate raider Gordon Gekko struts about at the annual meeting of Teldar Paper, points to the assembled pantheon of executive vice presidents and lashes out at the top-heavy management sucking out shareholder value.

So there is a paradox among paradoxes. Investors demand top-notch management; yet for many fledging ideas transitioning to market, such management runs the risk of extracting more cost than value - scaring away the very same investors.

Overbearing overhead

A full corporate structure accompanying top-flight management also requires substantial overhead. The ascendancy of the virtual company has been much heralded, but 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 have helped to mitigate some of this operational overhead, but many of these incubators suffer from one fundamental problem. Namely, they have a strong disincentive to have their rent-paying, start-up tenants move up and out. This mutual dependency (or “weaning”) problem has the paradoxical effect, even if psychological, of potentially slowing down development within these incubators.

Gary Pisano of Harvard Business School - in his book Science Business - has also pointed out how operational paradigms, which may have been appropriate to software technology development, have likely encumbered early-stage life sciences companies. I have argued previously that holding companies that effectively specialize in life sciences "interim management" might more efficiently allocate human capital among multiple, promising projects. Combining this with an upgraded “incubator” model that addresses the weaning problem would result in what I would term a “Life Sciences Accelerator” - an idea which I will develop more in a later column.

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 (or rate-limiting) step in that process. The Innovation Gap is more than just a sad litany of promising ideas snuffed out and laid to rest but rather, in my estimation, 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, and while it is difficult to quantify (in strict kinetic terms) a process which involves multiple parallel, diverging, or converging paths, I would say the major barrier (e.g. the rate-limiting step) is the innovation gap.

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

Previous articles by Ogan Gurel

Barriers will not stop convergence of medical technologies

Ogan Gurel: Abbott vs. Thailand has implications for innovation and access

Ogan Gurel: Personalized medicine and technology convergence

Of private equity, research, and drug development

Ogan Gurel: What patients want: A story of choice, clinical trials & evidence-based medicine

Ogan Gurel: Healthcare of business: Universal coverage plan includes new business taxes

Ogan Gurel: And the winners in medical design are…

Dr. Ogan Gurel is chairman of the Aesis Research Group, which provides forward-looking information and research services to the healthcare and life sciences investment community. Gurel was previously CEO of Duravest, a publicly traded Chicago investment company that initiates and develops next-generation medical technologies. Previous to Duravest, he was a vice president and medical director at Sg2, a healthcare intelligence think tank and consultancy serving hospitals and health systems. He can be e-mailed at ogan@midwestbusiness.com.

This article previously appeared in MidwestBusiness.com, and was reprinted with its permission.

The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of Wisconsin Technology Network, LLC.

WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.

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