Building a Business > Managing risk

Published online: 26 September 2005, doi:10.1038/bioent881

Virtual reality: the promise and pitfalls of going virtual

*Hal Broderson is at Rock Hill Ventures, 100 Front Street, Suite 1350, West Conshohocken, Pennsylvania 19428, USA. hal@rockhillventures.com

Because of their scale and cost advantages, virtual biotechs are attracting growing interest again. In theory, any element in the innovation chain of a biotech or medical device firm can be outsourced. In practice, the virtual model represents challenges to both investors and management.

Are virtual companies back in vogue now that outsourcing has come of age and investors are increasingly risk-averse about traditional early-stage biotechs? After a long hiatus, it appears that they are, at the very least, getting a fresh look. At this year's annual Biotechnology Industry Organization (BIO) conference in Philadelphia, Pennsylvania, a panel devoted to virtual biotechs attracted a surprisingly robust audience. The last time BIO devoted a panel discussion to virtual biotechs was in 1996. I led both this year's panel and the one in 1996.

Before virtual biotechs are anointed the next big thing in biotech, however, it's worth taking a closer look at them. Much has been written about the utility and pitfalls of outsourcing in mature (cash flow–positive) companies^1,2. Studies, however, on outsourcing in early-stage biomedical startups or other negative cash flow organizations are scant. And there is little agreement about the precise boundaries between a virtual company and a fully integrated biotech. We define a virtual company as one that is, for all practical purposes, outsourcing every major component of drug discovery and development to an outside contractor.

A virtual biotech is not merely a startup that is young or has a staff under a certain head count. Likewise, it is not a company that hires out bits of its own development work like toxicology tests or clinical trials—things that are expensive to perform in-house not least because they require large, skilled staffs. It's not size that matters, but rather the degree to which the physical process of developing a biomedical product is carried out in-house versus externally through contractors. A virtual company outsources practically everything. One example of a virtual company that is well known in biotech circles is the San Francisco-based Institute for OneWorld Health, which is managing the development of medicines for the developing world without actually performing any of the research and development of these medicines (see Box 1).

There's got to be a better solution

Startups fail most often because they run out of capital and experience product setbacks that management finds impossible to surmount. Of the two, of course, access to capital is the most insurmountable³. A company with adequate capital can typically navigate the product surprises that confront every startup. It is easy to forget that unlike a software company, a biotech startup's capital needs have always been enormous and probably always will be—at least until a new model is refined that reduces capital requirements.

Investors are pouring ever larger amounts of capital into startups these days because the new mantra is that biotechs have been failing, particularly in Europe, because they have been undercapitalized. The last 20 years have seen unprecedented growth in venture capital (VC) money under management. In the past, VCs typically raised initial investment rounds of a few million dollars and would raise about $20 million of private equity up to the point of exiting the investment either through an IPO or trade sale. Today, initial rounds of $20 million or more are viewed as essential and, therefore, have become commonplace. It is not uncommon to see $100 million in private equity poured into a biotech prior to exit.

Many health care entrepreneurs and investors have also convinced themselves that the ultimate goal of a proper startup is to reduce one's reliance upon subcontractors to nil. The buzz phrase for this model is Fully Integrated Pharmaceutical Company or FIPCO for short. For biotech companies, however, the FIPCO model has always been a mixed bag not least because of high cost and high risk. In a 2004 Wall Street Journal article, some of this sentiment was framed in a front-page story that concluded, "Biotech is a high risk, low return business except for the fortunate few.... As scientists search for cures, they gobble investor cash ... a handful hit the jackpot in the ultimate roulette game." The article concluded that without a drastic change in approach, biotech investors are better off investing in treasury bills⁴. According to Michael Gilman, executive vice president of research at Biogen Idec: "The solutions necessary are largely cultural and organizational rather than techical."⁵

Minimizing and optimizing the initial financing required by an early-stage startup can help reduce the risk associated with investing in biotech startups by reducing the amount of capital that is required to advance products to the point where an exit opportunity is possible. Earlier this year, Rock Hill Ventures analyzed 20 biomedical firms in various stages of development. Most of these firms were focused on developing therapeutics. Although most of the FIPCOs that we analyzed had expensive laboratories and extensive infrastructure, their technology assets were rarely ready for clinical development. The more important point is that most of these firms had spent money on things that could easily have been hired out like toxicology tests, assay development, regulatory affairs, manufacturing, clinical trial monitoring and management support.

To get a more definitive picture of this cost conundrum at biotech startups, a larger sample size and more in-depth analysis is necessary. Still, our analysis confirmed our suspicion that the virtual model has, at the very least, some key advantages that are not well understood in the VC and biotech fields(see Box 2).

The upside to going virtual

The most distinct advantages of the virtual biotech model are its cost structure and flexibility advantages over traditional business models. Startups are often caught off guard by the spiraling costs and increasing complexity of preclinical and clinical trials. Indeed, few things cost more or create more management bewilderment than clinical development. It is in this stage that startups see their burn rate, or more simply put, their variable costs, increase dramatically because the work load and product development complexity rise with each passing month.

The path of clinical development is only as wide as the company is flexible. Flexible companies can choose the most optimal clinical development path. Inflexible companies have fewer options, and therefore often find themselves confining their strategic clinical development decisions to those that fit their internal core competencies. The virtual model gives management the flexibility to tap a vast network of clinical development talent—without actually bringing them in-house. The virtual model allows management to hold the burn rate down and often allows it to evaluate competing development paths proposed by a network of experienced contractors with the degree of objectivity that is often not possible when clinical development recommendations are coming from the startup's internal management team.

The virtual model offers management and investors the potential to create a highly flexible company capable of expanding or narrowing the scope of product development within a minute's notice. For example, companies can delay the decision to expand into a more expensive integrated business model until critical go-no-go milestones are met and/or there is a favorable fundraising environment without worrying about the waste this might create because it would leave high-priced staff idle during the interim.

In other words, the virtual approach gives startups the ability to quickly adjust burn rates up and down over time. This is particularly useful during the critical period of preclinical development. In a typical startup, one would expect expenses to increase consistently over time because of fixed costs and intrinsic growth. Thus, if one were to graph temporal burn rates for a typical FIPCO startup, a series of positive slopes would be expected. This pattern is not seen with the virtual business model. This flexibility in burn rate creates huge gains in efficiency.

Beware of the downside

The most obvious disadvantage of the virtual model is the loss of control that comes with it. Specifically, by placing key tasks in the hands of contractors, risk and uncertainty can increase. Contractors are delayed by the same issues facing all companies such as employee turnover, management reorganizations and changes in strategic focus.

Since virtual companies typically juggle four or more contractors, the risk of delay is compounded. When these delays occur, larger clients (that is, those with potential for repeat business) will get priority. Without aggressive oversight, few contractors will share a startup's sense of urgency.

These problems are even more pronounced with overseas contractors, not least because face-to-face meetings with the contractors are always required. In general, the greater the distance from the contractor, the greater the challenge. At the very least, the cost advantage of using overseas contractors is quickly eroded by the loss of efficiency.

Building the right management team

Some believe that virtual companies can skimp on management expertise. To the contrary, virtuals need even more management experience than traditional startups. In particular, they require broad knowledge of drug development to understand how each contractor's piece fits into the overall development plan.

It is rare to find senior executives with both the ability and the desire to become as hands-on as is required. Traditional firms have redundancy built in and rarely place all key decisions with a single individual. Virtuals do not have this luxury. Each member of the core management team needs to be comfortable in an entrepreneurial environment where conflict is common and decisions are made quickly.

Virtual company management requires unusually expert project management skills. Tasks, goals, objectives, deliverables and deadlines need to be explicitly communicated. Problems need to be identified early. Management must have experience solving problems that arise between contractors, who often tend to blame each other for delays and errors. Experienced management teams can resolve these conflicts quickly and keep development on schedule. The tell-tale sign of a management team that lacks industry and virtual model experience is one that allows contractors to hijack development. Experienced management will have multiple and redundant systems in mind, but they will also be able to avoid many problems simply because of experience with the world's drug discovery and development contractors.

Much has been made of Pfizer's recent decision to acquire Angiosyn, a virtual biotech barely 3-years old, in a deal that could be worth more than $500 million to Angiosyn if milestones are achieved.⁶ The La Jolla, California-based Angiosyn is developing a novel approach to restoring vision in those suffering from macular degeneration. The Angiosyn acquisition augments Pfizer's Macugen product franchise and bolsters its research commitment to angiogenesis-related approaches to ophthalmology, particularly macular degeneration, in which uncontrolled blood vessel growth can lead to decreased vision and blindness. Less well known is that Angiosyn is a virtual company—an extremely well run virtual that in less than three years, for less than $5 million, proved the potential of both the product and the management team.

Without reading too much into the role that Angiosyn's virtual model played in the firm's success up to this point, it is safe to say, at least, that Angiosyn indicates just how rapidly and cost effectively a virtual can advance a product.

Conclusion

The virtual model is really just a vertically integrated outsourcing enterprise. At its best, the virtual model allows firms to focus their energy on core competencies and accomplish more with less. At its worse, this outsourcing transfers key activities outside the control of the firm where poor oversight or an unwise choice of contractors can lead to costly delays and failure.

Properly assembled and managed, virtual companies can be relatively more cost-effective than the traditional model for biotechs. These cost efficiencies are possible because there is burn rate flexibility to generate valuable clinical efficacy data quickly using a minimum amount of high-cost investor capital.

Once this efficacy data is generated, and investors and corporate partners are satisfied that management at the virtual company has delivered the milestones as promised, a startup will quickly find itself in a strong position to either pursue more funding or attract the attention of a company that might be in a position to acquire it. Management at virtuals that fail to achieve milestones should seriously consider whether failure is due to something external or their own inability to execute the virtual business model.

By using the virtual model, one can expect log-order reductions in early capital requirements while maximizing efficiency. This, in turn, can lead to enlightened product development and reduced timelines. Investors and companies looking to acquire promising startups are paying closer attention to virtual biotechs not least because these companies lower the risk associated with developing promising biotech products. Reduced risk represents increased upside potential for all stakeholders (see Box 3).

References

1. Barthelemy, J. & Adsit, D. The Seven Deadly Sins of Outsourcing. Academy of Management Executives report, 17, 87–101 (2003).

2. Arbaugh, J.B. Outsourcing intensity, strategy, and growth in entrepreneurial firms. Journal of Enterprising Culture 11, 89–110 (2003).

3. Guithes-Amrhein, D. & Katz, J.A. Cash Flow as a Factor in the Mortality Risk of a Business. Proceedings of the 43rd ICSB World Conference "Entrepreneurship at the Threshold of the 21st Century," June 9, 1998, Singapore Suntec Center (International Council of Small Business, Washington, DC 1998).

4. Hamilton, D. Biotech's dismal bottom line: more than $40 billion in losses. The Wall Street Journal May 20 (2004), p.1.

5. Bernstein, K. & Flores, D. Innovation and Economics. Biocentury, 13, A3 ( Sep 5, 2005).

6. Mack, G.S. Early-stage exits: Sometimes, less is more. Bioentrepreneur, 10.1038/bioent865 (June 2, 2005)