Why have so many legitimate smaller biotechs sprung up and thrived?

Question

I stumbled this question on r/AskScienceDiscussion, but I'd like to ask it from a microeconomics or competition standpoint.

Why can't Big Pharma accomplish what legitimate small biotechs have? Unquestionably Big Pharma has more money and can corner the market. Thus how could smaller biotechs have dawned at all? E.g. Regeneron collaborates with with Bayer and Sanofi. I'm not referring to potential pump-and-dumps like Moderna.

In Q1, Regeneron made over \$281 million from its Bayer partnership, primarily stemming from Bayer's sales of Eylea outside the U.S. It made nearly $247 million from its Sanofi collaboration, with immunology drug Dupixent the primary contributor.

FDA approved Neurocrine Biosciences`s valbenanzine in 2017. Neuocrine has collaborated with Eli Lilly and Company in 1996, GlaxoSmithkline in July 2001, Pfizer in Dec 2002, AbbVie Inc in 2010. But why didn't these Big Pharmas acquire Neurocrine?

On Jul 13 2020, Amgen doubles down on BeiGene investment. On Jul 15 2020, Nabriva inks Sivextro distribution with Merck. On Aug 6 2020, FDA lets NeuroRx, Relief Therapeutics test RLF-100 in COVID-19 patients, but why haven't Big Pharma bought out or hostilely taken over these biotechs?

In R&D, small biotechs hold their own against big pharma | BioPharma Dive

Despite spending billions on R&D, big pharma doesn't punch its weight in discovering the new molecules that eventually make it to market.

Instead, it's often the smaller biotechs which are responsible for uncovering promising new therapeutic approaches, an industry maxim backed up by an April report from research group Iqvia.

Answer 1

I would prefer to take a broader tact with this: Why aren't all firms bought at a smaller size? Why are there any small R&D firms?

One answer is related to uncertainty.

1. Some firms look like they will be profitable, but they are not. Perhaps their research fails: they cannot get approval, the drug doesn't work, or it has severe undesirable side effects. This uncertainty is part of the business.
2. Firms produce signals of their quality. The signals reduce uncertainty and it becomes clearer which startups will be profitable, increasing their prices. Owners will be less willing to sell, and other buyers will make competing offers.
3. The increased price of the firm leads to a larger asking price, so any net profit of purchasing the new firm is reduced.
4. Since the profit margins are reduced, the remaining uncertainty leads to continued hesitation in purchasing.
5. This process continues until the small startup is no longer small enough to buy.

Sometimes, a profitable firm can be identified with sufficient certainty before the final step 5, and that is where you see purchases.

Answer 2

This is actually two questions. Each is interesting in its own right.

1. Why have so many legitimate smaller biotechs sprung up and thrived?

• Difficult to say (perhaps some industry insider might be able to provide additional insight), but one possible explanation is that most of the frontier research in this sector happens in universities. Academic researchers might be more likely than big pharma researchers (who might prefer less risky projects) to pursue an idea for a completely new drug, in which case they might want to develop the drug through a startup in order to retain intellectual property and control over the project. This might explain why there's a vibrant startup scene in biotech and not all of the innovation is happening in large firms, although there's obviously exceptions. Once the drug is at a more advanced stage of development, often the startup is sold to a larger company.

2. Why haven't Big Pharma bought out or hostilely taken over these biotechs?

• In many cases, they have, actually. Sometimes they are not even looking to develop the new drug, but just to buy out potential competitors. There's actually a paper forthcoming in the Journal of Political Economy that documents this happening frequently in the pharma industry.

Answer 3

Growth of assets is financed by debt, equity, or retained earnings. Going concern investments are efforts to purchase assets with expected profits which become retained earnings. Venture investments are not financed from retained earnings. The new debt and/or equity funds are invested in a venture which may or may not reach cash flow breakeven in the near or distant future.

Large firms tend to make strategic acquisitions of small firms with intellectual property and innovative products and where assets must expand rapidly to capture more revenue in commerce. This is often a venture investment within the large firm with a plan to make breakeven cash flow on further investment efforts. If there is a long term loss in the venture then the firm must absorb the cost of a bad acquisition and other investments in the failed venture business model.

This six page paper on Biotechnology Innovation says 90% of firms do not earn a profit. This means large firms would take a loss or pay more overhead costs out of profits if they attempted to bring all the R&D loss onto their balance sheets:

https://www.bio.org/sites/default/files/legacy/bioorg/docs/Whitepaper-Final.pdf

If large firms had a profit incentive then governments, universities, and small innovative firms would not be necessary to subsidize the losses associated with innovation. Those who compete to make a loss are in the innovation business whereas large firms are not as eager to compete when there is considerable risk of financial loss.

When equity is used to finance innovation the write-off of a loss is a reduction of net worth of the equity investors who ideally are willing and able to take the high venture risk.

When government funds are used to finance innovation this would increase either government debt or taxes and the subsidy does not necessarily provide any income producing asset for the government in the long run. The losses are not written off as rapidly when the government provides the subsidy finance for risk ventures.

In terms of competition you subsidize the toddlers and let the teenagers begin to compete so the elderly and wealthy established households can have real resources and a bigger net worth. If you want clean energy, for example, and dirty energy has been subsidized by past generations, then society must subsidize the new technology because the old technology has economies of scale and sunk R&D costs.

Answer 4

It is not uncommon to see revenue and profit histories of biotech companies that as of today probably cannot be described as thriving. This is especially true of the smaller market cap equities. BeiGene is not a small company so I will not comment on it. An internet search shows Nabriva lost money every year from 2016 to 2019 inclusive. An internet search shows Relief Therapeutics has minimal revenue. These small companies might have profits in the future but on a financial basis it would be hard to characterize them as thriving.

More relevant to the question of being acquired is the matter of price relative to value. It is not easy to decide on a financial and technological basis that these two small companies are trading for less than they are worth and should be immediately acquired. If it were easy then the opportunities would have already been taken.

On the other hand, as RegressForward correctly says in his answer, the apparent success of a small company means the price to acquire it will increase to the point where you are uncertain if it can be acquired for less than what it is worth.

A certain kind of person might be attracted to Big Pharma. On the other hand if a person has startup relevant skills they are incentivized to work for a smaller biotech. As long as the rate of startup creation is greater than the rate of failure plus the rate at which they are acquired, then the number of small companies will not trend toward zero. If the number is not zero then there will always appear to be small companies in what might be an attractive industry.