Magazine Winter 2016 Research Feature

Lessons From Hollywood: A New Approach To Funding R&D

Companies find it challenging to justify long-term, risky R&D investments — particularly in science-based fields such as biotechnology. Maybe it’s time to consider a different financing model.

Andrew W. Lo and Gary P. Pisano Reading Time: 33 min 

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Hollywood Finance Funding Research Development
Could science-based industries benefit from a financing model similar to one used to make Hollywood movies?

Science-based industries such as biotechnology offer the potential of high growth, but they are fraught with risk. The payoffs, if they ever come, can take many years to materialize. Amid intensifying capital market pressures for short-term financial results, even large and successful companies are finding it increasingly challenging to justify longer-term risky research and development investments. The challenge is particularly acute in research-intensive fields including biotechnology, nanotechnology, and advanced materials, which involve massive R&D investments, extended gestation lags before investments bear fruit, and high risks of failure.

Many would argue that given these requirements, such industries don’t lend themselves to corporate R&D and are more suited to early-stage venture capital (VC) investment. However, even though the traditional venture capital/entrepreneurial model has been shown to stimulate innovation in a wide range of technology settings (software, computers, Internet, electronics, etc.), it wasn’t designed to deal with the costs, risks, and slow payout of science-based industries. In biotechnology, for example, the journey from basic scientific discovery to fully approved drug can span 10 to 20 years and require investments exceeding $2 billion. Moreover, only a tiny percentage of drug R&D projects ever result in approved drugs; a recent study in Nature Biotechnology calculated a success rate for drug development from initial indication to approval by the U.S. Food and Drug Administration (FDA) of only 10%.1 The success rate was only about 7% in important therapeutic categories such as oncology. In comparison, the Google search engine was operating on Stanford University computers about a year after Sergey Brin and Larry Page, cofounders of Google Inc., began collaborating on their research. Although venture capital continues to flow into industries like biotechnology, there has been a significant shift away from funding ventures at the earliest stages of the R&D cycle.2

The typical science-based business startup is not unlike a long-range multistage rocket mission: Each stage must fire perfectly for the next step of the mission to begin. If any stage fails to execute, the entire mission fails. Even investors with a high tolerance for risk are deterred by the uncertainty of the risk — the “unknown unknowns” associated with a lack of well-defined indicators of day-to-day performance.

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About the Authors

Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. Gary P. Pisano is the Harry E. Figgie Jr. Professor of Business Administration at Harvard Business School.

References

1. M. Hay, D.W. Thomas, J.L. Craighead, C. Economides, and J. Rosenthal, “Clinical Development Success Rates for Investigational Drugs,” Nature Biotechnology 32, no. 1 (January 2014): 40-51.

2. For example, there are fewer first-time Series A financings in recent years, down 30% from a peak in 2006, according to D. Thomas and C. Wessel, “Venture Funding of Therapeutic Innovation: A Comprehensive Look at a Decade of Venture Funding of Drug R&D” (Washington, D.C.: Biotechnology Industry Organization, 2015).

3. R. Nanda and M. Rhodes-Kropf, “Investment Cycles and Startup Innovation,” Journal of Financial Economics 110, no. 2 (November 2013): 403-418; and R. Nanda and M. Rhodes-Kropf, “Financing Risk and Innovation,” Management Science, in press.

4. R.H. Coase, “The Nature of the Firm,” Economica 4, no. 16 (November 1937): 386-405.

5. G.P. Pisano, “Science Business: The Promise, The Reality, and the Future of Biotech” (Boston, Massachusetts: Harvard Business School Press, 2006).

6. As Academy Award-winning screenwriter William Goldman put it: “Nobody knows anything. Not one person in the entire motion picture field knows for a certainty what’s going to work. Every time out it’s a guess — and, if you’re lucky, an educated one.” W. Goldman, “Adventures in the Screen Trade: A Personal View of Hollywood and Screenwriting” (New York: Warner Books, 1983): 39.

7. See www.ispy2trial.org.

Acknowledgments

The authors wish to thank Chris Austin, Hubert Birner, Belen Carillo-Rivas, Francesco De Rubertis, Ansbert Gadicke, Jose Carlos Gutierrez-Ramos, Neil Kumar, John Rehr, Tom Rutledge, Christiana Stamoulis, and Nora Yang for their helpful comments and discussion, and Jayna Cummings for editorial comments. The authors gratefully acknowledge research support from the MIT Laboratory for Financial Engineering and the Harvard Business School Division of Faculty Research and Development. The views and opinions are those of the authors only, and do not necessarily represent the views and opinions of any institution or agency, any of their affiliates or employees, or any of the individuals acknowledged above.

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Comment (1)
Knowledge Capital
Seems similar to the model already implemented by many tech Studios such as Expa and Betaworks. No?