Competition to license pharmaceutical compounds is becoming fierce. Drug companies used to rely solely on their own discoveries to deliver the next miracle cure. Nowadays, they are increasingly likely to license compounds discovered by others. These companies resort to licensing to beef up their product ranges and to satisfy their investors’ growth expectations, and because the risk-adjusted cost of doing so, their executives believe, is less than that of developing alternatives in-house. But as licensing grows more popular, the number of competitors vying for deals increases, negotiations and accords become more complicated, and costs rise.

Just getting a seat at the bargaining table can be difficult because the price is often so high, and organizations with compounds to license want to deal only with the strongest potential partners. Rockefeller University limited the number of contenders in the final round of negotiations for licensing rights to an obesity-related gene discovered by its scientists, and it then used an auction-style mechanism to push up the price to $20 million. Pfizer is expected to shell out $225 million, including an up-front payment of $85 million, as part of a 1998 agreement with Searle (Monsanto’s pharmaceutical division) to develop the promising anti-arthritis treatment celecoxib¹ and its second-generation compound and to co-promote it in the United States. Analysts estimate that the final cost to Amgen of its deal to license neurotrophic agents from Guilford Pharmaceuticals could be as high as $450 million.

Competition will grow still more intense and prices will rise. But, our research indicates, corporations expect in-licensed products (those one company licenses from rather than to another) to generate an ever larger share of their business—in some cases, as much as half. Licensing certainly meets some short-term needs. It can bolster product pipelines that executives regard as insufficient to satisfy the expectations of growth implied by their companies’ sky-high valuations in financial markets. It helps big companies exploit innovations in biotechnology and other areas that complement homegrown products. And it supplies companies that have large sales and marketing forces with a wider flow of new compounds.

Few companies bother to track the relative profitability of internally and externally developed drugs

But does it pay? Our interviews with licensing executives at 25 leading pharmaceutical manufacturers, several midsize pharmaceutical firms, and a number of biotechnology operations revealed that companies can reap significant rewards from pharmaceutical licensing. Indeed, more than 90 percent of the respondents expected revenues from in-licensed products to increase over the next five years. Most licensing executives assert that investing in externally developed compounds is at least as beneficial financially as investing in internal research. Yet there is scant evidence for these conclusions, because few of the companies we surveyed bother to track the relative profitability of in-licensed products.

With pharmaceutical executives diverting a greater share of corporate resources to licensing (Exhibit 1), it is fair to question whether and when overbidding might begin to turn it into a money-loser. Although there is no sign that this has happened to date, the companies that avoid this trap would probably be those applying superior scientific and commercial insights, deal-making skills, and organizational abilities to the mechanics of licensing. Tapping the promise of licensing in an ever more heated environment will be neither cheap nor easy.

The rise of licensing

No doubt there has been method to the licensing madness, for of late some of the most promising and celebrated drugs have been licensed compounds. The cholesterol-lowering Lipitor, for example—expected to be the world’s top-selling drug by 2005—has been comarketed by its developer, Warner-Lambert, and Pfizer. Johnson & Johnson’s largest seller is the anemia drug Procrit, which is licensed from Amgen. In all, 14 of the 55 blockbuster drugs—those with annual revenues of more than $500 million—marketed by the ten largest pharmaceutical companies in 1998 were licensed from external sources (Exhibit 2), mostly after the proof-of-concept phase. For these ten companies, revenue from licensed compounds has risen from 24 percent in 1992 to 32 percent in 1998, an increase that translates into a 15 percent compounded revenue growth rate, compared with 9 percent for products developed internally. By 2002, we believe, the ten companies will get 35 to 45 percent of their revenues from externally sourced products.

Some companies have gone so far as to build entire businesses on in-licensing. Bristol-Myers Squibb—whose oncology operation rests on such in-licensed drugs as Paraplatin, Platinol, and Taxol—derives more than 95 percent of its oncology revenues from in-licensed products. All of its oncology products in late-stage development are in-licensed.

Other companies find that licensing helps them manage the market’s expectations. Investors in Pfizer, for example, have awarded the company a growth premium, apparently in the belief that it will repeat the late-stage licensing successes it has had with Aricept, Celebrex, and Lipitor. We expect more than a quarter of Pfizer’s near-term growth to come from in-licensed products that the company has obtained or plans to obtain over the next five years on the basis of its reputation as a desirable partner.

The contest for compounds

Since licensing holds out such promise, it is no surprise that more and more companies are struggling for the best opportunities. Our research suggests that the average number of competitors vying for a particular compound has increased sharply (Exhibit 3).

Meanwhile, good opportunities are becoming harder to find, so companies have had to become more sophisticated at spotting and capturing compounds before their value becomes widely apparent. The executives we surveyed believe that both licensors and competing licensees are better informed, quicker to act, and more aggressive in negotiations than they were five years ago.

For example, biotechnology companies—an important source of exciting compounds and technologies—are becoming more independent: now that contract research and sales organizations have become credible outsourcing options, many biotechnology players can keep compounds in-house rather than license them. From 1995 to 1998, the US Food and Drug Administration allowed biotechnology companies to launch 53 drugs; from 1991 to 1994, it approved only 20.

Heightened competition isn’t the only force driving up deal prices. The discovery of more potent and complex molecules has led to more intricate deals, such as Amgen’s agreement to license from Guilford neurotrophic agents that target ten medical indications. In another case, Metabolex granted Abbott Laboratories the rights to the Metabolex diabetes program and received cash from John Hancock insurance, which guaranteed its investment by obtaining a put option from Abbott. The result was a creative, off-balance-sheet deal structure that saved Abbott from a near-term profit-and-loss hit.

As the appeal and cost of licensing rise, companies must make sure the deals they enter will pay off. They can do so by mastering tactical execution, but only after defining a portfolio strategy. Companies must determine their overall priorities, the expectations of their shareholders, their competitive positions in each therapeutic area, the quality and volume of their research-and-development projects, and their organizational capabilities. Only then should the focus shift to the question of whether to develop drugs internally, to license them, or to acquire the companies that developed them.

Enriching the deal flow

The experience of venture capital firms seems to show that the most attractive deals usually don’t originate with the licensors

One remarkable finding of our research was that many deals originate with the licensor. Although this may be fine for a company whose market position in a particular therapeutic area is strong enough to attract the best partners—Bristol-Myers Squibb in oncology, for example—the experience of venture capital firms indicates that deals arriving that way are rarely the most attractive.

Venture capitalists and private equity investors thrive on the ability to spot the best opportunities and to close deals before competitors can move. Pharmaceutical companies following this example develop "hunting" lists of the compounds that interest them most and create (and periodically revise) processes to monitor, approach, and cultivate potential licensors. Creating the list entails resolving disagreements about priorities and generates momentum toward a common goal.

The scientists who work for corporate research-and-development organizations are a generally overlooked source of high-quality leads. Companies can improve the collaboration between their R&D and licensing divisions by introducing stronger incentives and organizational structures and by getting their R&D directors involved in the planning and execution of deals. One of the most effective ways to exploit the natural affinity between licensing and R&D is by having the licensing group report directly to the head of research. Companies that take this approach also instruct their R&D personnel to scan conference proceedings, public databases, and scientific literature for compounds that could be licensed. In addition, they have found that by rotating R&D staff into their licensing organizations, they can promote closer, more productive links between the two.

Improving the assessment of deals

Company scientists can not only spot opportunities; they can also help evaluate them. Johnson & Johnson, for example, decided to acquire the Alzheimer’s drug galantamine from Shire Pharmaceuticals Group when J&J scientists concluded that the compound, derived from natural sources, could be produced synthetically and thus inexpensively. Top licensing operations consult external scientists as well.

Yet even companies that land promising products can fail to judge the market accurately. They might, for example, overestimate the extent to which the medical community will adopt their drugs, fail to anticipate their competitors’ reactions, misjudge the responses of group-purchasing organizations (GPOs),² or be forced to struggle with unclear reimbursement models, especially outside their home markets. But after observing superior practitioners like Pfizer, we have come to believe that companies can avoid such problems by making significant—perhaps lavish—up-front investments in commercial due diligence.

A licensor exposed to a suitor’s well-grounded research is less likely to overreach while negotiating terms for a deal

Pfizer and similar companies start by scrutinizing the patents pending of any prospective licensor, as well as its manufacturing processes, regulatory filings, clinical work, and market analyses. They then conduct their own market research—including field interviews with consumers, physicians, GPOs, and government authorities—to make a realistic assessment of a compound’s commercial prospects. A suitor often shares this research with the prospective licensor in the hope that it will conclude that the suitor offers the best hope of maximizing royalty payments down the line. Moreover, a licensor exposed to well-grounded market research is less likely to overreach in negotiating terms.

Assessing a deal’s value is important in view of the substantial inherent technological and market uncertainties of the drug business, particularly when early-stage compounds are involved. Although conventional valuation tools (such as net present value) may sometimes be fairly adequate, options-based techniques can help a prospective licensee judge the full value of an asset by quantifying the effects of its uncertain future and of the licensee’s ability to bail out should things go badly.³ Most licensing executives are now exploring new valuation techniques, though fewer than 10 percent of the people we surveyed actually employed them. We expect this state of affairs to change, and quite soon.

Finding desirable partners

How can an aspiring licensee make itself more attractive? For starters, it can provide strong answers to the four questions at the top of most licensors’ minds. How much larger can the pie become with the help of this partner? How large will my share be? Can my company work effectively with these people? Will they deliver?

First and foremost, a prospective licensee must show strength in the relevant therapeutic areas and argue convincingly that that will maximize a product’s value. The licensee can emphasize its regulatory savvy, its market position, its expertise in sales and marketing, or the quality of its clinical research. Bristol-Myers Squibb, for instance, has the largest oncology sales force and a long-standing record of licensing and developing such cancer drugs as Taxol and Paraplatin; Pfizer captured the rights to Celebrex by dint of sales and marketing expertise and a record of co-promoting products such as Lipitor and Aricept.

Licensees win additional points by being flexible about the structure of deals. Pfizer, for example, won its license for Lipitor from Warner-Lambert partly by agreeing not to record any revenues from that drug on its income statement, thus permitting Warner-Lambert to reap the full top-line benefit of Lipitor’s sales. Licensees hoping to attract the best partners should also strive to build high-quality relationships with their senior managers and scientists; Allergan’s deal with Warner-Lambert to develop diabetic retinoid therapies was sealed in record time, thanks in part to strong personal ties.

Moreover, the best partners give prompt and unambiguous responses and avoid costly delays. Although most companies aspire to turn deals around in three to six months, usually they take longer than nine—mainly, according to the licensing executives we surveyed, because of the time it takes to build internal consensus. Companies can speed up deals by streamlining approval processes, creating teams that work solely on due-diligence searches, and developing boilerplate agreements that can be tailored quickly to particular situations. At the end of negotiations, successful or not, the partners in greatest demand collect feedback on their licensing practices from their negotiating partners.

Once a product has been acquired, the next step is to integrate it into the development and commercialization pipelines. Many of the licensing executives we surveyed are coming to realize that integration is a key to success, though few believe that their companies handle it very well. While some companies neglect compounds they have acquired rather than originated, leading practitioners judge all compounds by the same criteria and make no distinction between the two groups in the development and marketing phases. To oversee the entire integration process, these companies appoint strong, accountable project leaders drawn from deal teams.

A world-class licensing organization

Licensing operations should not be parking lots for executives who are weak or close to retirement

Our research suggests that in the effort to create responsive licensing organizations, structure matters less than personnel and processes. The best organizations tend to be tight-knit groups of five to ten high-powered people recruited—from venture capital firms, investment banks, consulting firms, and competitors—for their business, scientific, legal, and transactional skills. Contrary to the practice of many companies, the licensing operation should not be a parking lot for managers who are close to retirement or can’t cut the mustard in other parts of the organization.

Licensing executives should be paid on the basis of performance—reckoned, for example, by the number of in-licensed compounds they obtain that meet the company’s scientific and commercial expectations. Compensation for the head of R&D could be based partly on licensing performance. And to send a signal to the organization as a whole about the importance of licensing, there should be greater parity between the pay of senior R&D executives and that of their licensing counterparts, who typically earn 20 to 40 percent less.

At the corporate level, financial forecasts must accurately reflect planned investment in licensing activities. Exciting deals should not be turned down solely because they might dilute short-term earnings. In general, companies ought to allocate their resources strategically among R&D, licensing, and acquisition at the beginning of the year, and in any event well before they choose deals; budgets can then be approved on a deal-by-deal basis. A failure to adopt budgets ahead of time sometimes prevents companies from entering into otherwise attractive agreements, especially if it is late in the year and they are under earnings pressure.

Strong practitioners also coordinate their activities to ensure early consensus, frequent feedback, and rapid execution. Many hold monthly meetings at which the heads of R&D, licensing, marketing, legal counsel, and finance review progress toward key targets, check the deal pipeline to see how full and fast-moving it is, and discuss ways of generating deals.

Even though competition to secure deals is heating up, most pharmaceutical companies don’t know how much value licensing can create. But the growing gap in market capitalization between master deal makers and the also-rans should tell the latter that even if they minimize the importance of becoming a world-class licensing organization, investors will not.