Thinking about Life Sciences: The ‘Innovation Gap’: Preventing Ideas Fr... http://blog.aesisgroup.com//2007/05/29/the-innovation-gap-preventing-id...

Thinking about Life Sciences

http://blog.aesisgroup.com

Wednesday, May 30, 2007

The ‘Innovation Gap’: Preventing Ideas From Untimely Deaths

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

1 of 4 11/17/2008 12:45 AM
Thinking about Life Sciences: The ‘Innovation Gap’: Preventing Ideas Fr... http://blog.aesisgroup.com//2007/05/29/the-innovation-gap-preventing-id...

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

2 of 4 11/17/2008 12:45 AM
Thinking about Life Sciences: The ‘Innovation Gap’: Preventing Ideas Fr... http://blog.aesisgroup.com//2007/05/29/the-innovation-gap-preventing-id...

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/

3 of 4 11/17/2008 12:45 AM
Thinking about Life Sciences: The ‘Innovation Gap’: Preventing Ideas Fr... http://blog.aesisgroup.com//2007/05/29/the-innovation-gap-preventing-id...

Venture Capital Biotechnology Private Equity Innovation Innovation Gap Aesis Research Group Ogan Gurel MD

4 of 4 11/17/2008 12:45 AM