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ENTREPRENEURIAL VENTURES ON THE MOVE:
CANADA ATTRACTS U.S. BIOTECHNOLOGY FIRMS
Rowena D. Ahern, Ahern & Associates Inc.
Michael B. Heeley, University of Washington
A goal of regional policy makers is to encourage high-tech firms to locate activities in their regions. This papers explores how Canadian policies are attracting firms in the biotechnology industry to locate product research and development activities in Canada. A theoretical basis is drawn from a transaction cost model of new product development which is used to explain why firms choose to out-source product development activities. Propositions developed in the model were explored through case study research. Results of the case studies provide mixed support for these propositions.
Attracting and retaining business activity is often a high priority of regional policy makers. Business that creates skilled jobs and fosters employment growth is especially attractive. High-technology firms, which are innovative and dedicate a relatively high proportion of their resources to research and development, are considered desirable additions to a regional economy. These firms tend to create high quality jobs and contribute to the long-term growth of a region (Malecki, 1991). Glasmeier (1991, p.1).captures the general attitude of policy makers towards high-technology activities, suggesting that they are, "...major components of local economic development wish lists." The promotion of R&D related activities has been an ongoing agenda of Canadian policy makers (Science Council of Canada, 1979).
The purpose of this paper is to investigate why U.S. biotechnology firms are relocating part or all of their product development activities to Canada. Three questions underlie this investigation. First, what regional conditions attract R&D activities? Second, what makes it possible for biotechnology firms to exploit regional advantages. Third, what role can policy makers play in fostering the growth of desirable R&D activities? To address the first of these questions, the following section offers a brief overview of the role of R&D activities in regional economic development, and the factors that make a region more or less attractive to firms undertaking R&D.
Much of the remainder of the paper is dedicated to the second question, regarding the nature of R&D in the biotechnology industry. The second section of the paper explores the process of new product development. Scrutinizing this process allows us to consider how the nature and organization of R&D activities enable biotechnology firms to take advantage of favorable regional conditions. The third section provides a theoretical foundation for the study by summarizing a transaction cost model of product development (Heeley and Ahern, 1995). This model focuses on how firms can increase the efficiency of product development by out-sourcing parts of the development process. Using this model as a base, the fourth section presents the propositions that guide our empirical investigation. The fifth section of the paper presents the research methods and case study research, offering empirical insight into the relationships between regional advantage, new product development, and policies promoting R&D activities.
The final section of the paper presents the conclusions and implications of the study. Here the question of what role regional policy makers might play in fostering the growth of R&D intensive activities is addressed. Conclusions are drawn about the characteristics of new product development that enable biotechnology firms to exploit regional advantages, and the ways policies can strengthen regional advantage and attract R&D activity.
Malecki (1991) notes that attracting high-technology activities is one of the most common goals of regional development policy. He describes the appeal of these activities as twofold. First, high-technology sectors are associated with higher innovation than other sectors. Innovation is, in turn, associated with higher rates of employment growth. Second, high-technology can help stabilize a regional economy as the growth in this sector tends to occur when there is a downturn in most other manufacturing sectors. Malecki (1991) however, also notes that the regional importance of high-technology may be overrated because the proportion of the work-force employed in high-technology activities is relatively low.
Although growth in the high-technology industries does not necessarily create a large number of new high-tech jobs, it may initiate growth in other sectors. A critical mass of firms helps generate the local linkages that create jobs in other economic sectors. Without local linkages, however, the regional development benefits of R&D activities is relatively small (Glasmeier, 1988). The agglomeration of related activities is an important aspect of attracting firms to a region (Scott, 1988). Over a century ago, Marshall (1890) pointed out the importance of location factors and agglomeration. He noted that certain benefits are realized by firms concentrating in a geographic region. These include knowledge spillovers, the establishment of subsidiary trades, and a constant supply of skilled workers. All of these factors affect the location of R&D activities and the likelihood that fostering high-technology growth will prove advantageous to a region. More recently Porter (1990) has reemphasized the importance of location factors, stressing the value of tax incentives in generating investment capital, and emphasizing that regional governments can help promote the growth of selected industries.
Canadian policy aimed at strengthening key technological sectors has existed for some time (Science Council of Canada, 1979). Largely because of foreign direct investment, Canada has had difficulty forming strong industrial agglomerations with local linkages. The nature of the economy, with a large number of foreign run subsidiary's and branch plants, has hindered economic growth, the development of technical competence, and the formation of a strong base of supporting activities (Britton, 1980; Britton, 1981). Policies promoting linkages between small and large firms, and providing support for innovative firms were formulated to try to reverse some of the adverse effects of foreign ownership (Science Council of Canada, 1979). The actual success of numerous and varied policies directed at fostering the growth and success of high-technology firms, however, appears to be limited (Britton, 1988).
It is possible that a more recent evaluation of Canada's technology policies would reveal more favorable results. Whether or not policies are effective in a general sense, they do appear to be successful in promoting specific activities. Funding for world class laboratories and financial incentives for R&D investment appear to have helped make Canada a desirable location for certain biotechnology activities. Extensive networking and out-sourcing in the biotechnology industry (Harrison, 1994) may make this industry particularly responsive to public policy initiatives.
NEW PRODUCT DEVELOPMENT
The development and commercialization of new products are vital to corporate profitability and growth. Companies that are successful in these activities enjoy significant performance advantages, (Booz et. al., 1982). This ability is nowhere more important than in technology-based industries such biotechnology, where the research and development of new products is the key lifeline of companies and thus critical to their strategic success, (Woiceshyn, 1993). Unfortunately, product development is not without risk. History is littered with cases of firms spending millions of dollars developing products that were commercially unsuccessful. Mansfield, (1981) found that only 20% of R&D projects result in commercially successful products or processes in the chemical, drug, electronics and petroleum industries.
The process of product development in the biotechnology is especially risky due to the high costs, and long development time, of new products. More than almost any other industry, biotechnology is capital intensive (Teitelman, 1989). The industry as a whole is not yet profitable and relies on investors to keep providing the necessary capital (Price, 1991). As the industry has matured, the competition for funding has intensified. Getting the most out of every research dollar is becoming a hallmark of the industry.
Traditionally, product development has been thought to consist of a number of distinct highly logical and ordered stages, (e.g. Cooper, 1983). The best known stage-process model is that of Booz, Allen, and Hamilton (1982) who utilize a ten stage approach in their analysis of the new product process. while stage models of new product development reveal a general process from an initial stage of strategy formulation and idea generation to a final stage of commercialization, there is no clear consensus as to the actual stages in this progression. Moore (1984) found that there was generally a large degree of overlap between the product development stage and other stages in his sample of firms. There is also limited empirical evidence that a particular number of stages, in a certain sequence, is necessary to maximize innovation efficiency, (Cooper, 1983). Interviews with entrepreneurs revealed that the process of product development in the biotechnology industry can only be characterized in broad terms. The following general stage model serves as the basis for our discussion of developing products in the biotechnology industry (figure 1.).
The primary concern of firms in the biotechnology industry is to reduce the time and cost of product development, while maintaining control of proprietary innovations. Concerns over time, cost, and control, are driving many of today's new product development practices. Time is a key factor because an important goal of innovative firms is to be the first to bring their product to the market. An innovating firm, by virtue of being first, gains a competitive advantage that allows it to reap super-normal rewards. For many innovating firms, minimizing the time taken to develop and commercialize the product becomes an overriding concern. This is exacerbated when the firm has a number of capable competitors for its target market1. As Doug Williams of Immunex says: "The question is who can get there quickest. Who can get there first. Because anything other than first is last." (McDermott, 1994). The risk of a competitor beating a firm to market is almost always present in the biotechnology industry.
Stage Model of The Biotechnology Product Development Process
In general there are two approaches to reducing the time to market. First, a firm can pursue different approaches to the same problem simultaneously. This might be a shotgun approach where many different things are tried with the hope that one will yield a solution. A second way of reducing development time is to undertake different tasks concurrently. Rather than progressing from one challenge to the next, a firm might work on two or more stages of product development at the same time. The concept of carrying out product development stages in parallel has recently received considerable attention in the innovation literature (e.g. Hill, 1993; Stalk and Hout, 1990). These two approaches to reducing the time to market result in either overlap between the general stages presented in figure 1, or overlapping activities within one of the stages.
Unfortunately, minimizing product development time is likely to conflict with the second concern, which is minimizing development costs. Analytic studies suggest a convex relationship between development time and cost. Total cost decreases at a decreasing rate, as time is increased (Scherer, 1984). This implies that, in general, as the time to market is reduced the costs associated with product development will increase. Containing costs in the biotechnology industry is a key aspect of maintaining the support of investors. During the long product development process, which averages between seven and ten years for therapeutic drugs (Lowell, 1991), firms usually require many rounds of funding. In order to keep raising the necessary capital, firms must show investors that their money will be spent prudently.
In addition to time and cost, maintaining control over technological innovation is a major concern in new product development. In order for a firm to earn returns on its R&D investment, it is important that no competitor expropriates the technological development and produces a competing or possibly superior product. Innovations in the biotechnology industry are protected both by patent and secrecy, (Daly, 1985). While certain innovations can be protected via patents, during the early stages of development it may not be possible or even worth filing a patent as technological uncertainties are still to be resolved. In addition, a patent provides information to potential competitors, J. Leslie Glick, the Chairman on Genex suggests that secrecy is more important than patenting (Daly, 1985).
In the next section we will examine the issues of time, costs, and maintaining control, using a model of new product development derived from transaction cost economics (Heeley and Ahern, 1995).
TIME, COST, AND CONTROL:
TRANSACTION COST THEORY AND PRODUCT DEVELOPMENT
Transaction cost theory provides a basis for understanding market exchanges. Fundamental to this theory is the assumption that efficiency is the key to an organization's survival and success (Coase, 1937; Williamson, 1975). While transaction cost theory typically focuses on the efficient choice between producing goods and services within the firm or purchasing them in the market, it applies to all economic activities involving a choice between internalizing or externalizing an activity.
The speed with which a task is accomplished is an important consideration that is not explicitly addressed within transaction cost economics. Time and cost are two different, and equally important, objectives that factor into the decision to internalize or externalize an activity. Only by separating time from cost can a transaction model of product development be developed. The consideration of time cannot simply be collapsed into the cost variable because the two are often in conflict. Reducing costs may mean lengthening the time needed to undertake a task. The separation of time and cost makes transaction cost theory a more robust framework for explaining the innovation process.
The facilities necessary for undertaking product development can be established within the firm or found outside of the firm. Because of the different nature of various stages of product development, different assets are required at each stage, a firm will have to make a potentially significant investment in specialized assets. Asset specificity is the degree to which various types of assets are dedicated to a certain transaction and cannot be re-deployed without a loss (Williamson, 1975). Specified assets, such as laboratory testing equipment, may only be useful for a short period of time during the development stage. These assets may be re-employable only after significant re-investment and even then they may not fit well with the firm's product development strategy or production needs. As a result the cost associated with investing in specified assets is acute in the development of biotechnology products.
The relationship between the number of tasks carried out simultaneously and the investment in specialized assets is likely to be positive. Firms that are trying to save time by undertaking activities simultaneously will be forced to dedicate assets (for example facilities, equipment, and trained staff) to support multi-tasking. In addition, firms that are exploring different stages of the product development process in parallel may have to commit resources that are later discovered to be inappropriate. The more tasks undertaken simultaneously, the greater the investment in assets that cannot be easily re-deployed.
Resourceful firms may be able to afford to invest in specialized assets, with a limited life, and can therefore do this internally. However, given the current investment environment, even the most resourceful firms may be reluctant to invest in internal capacity because it may be difficult to justify the expense to investors. In addition, new product development has been characterized as a highly uncertain process (Moenaert and Souder, 1990). It has been suggested that, in the face of high uncertainty, a firm should externalize transactions because of the risk of making investments in specific assets that have a high potential of becoming obsolete (Harrigan, 1984; Porter, 1980). Out-sourcing activities helps biotechnology firms address the problems of high cost and high uncertainty in the new product development process.
The problem with externalizing or out-sourcing product development activities is the high risk of opportunism. Opportunism occurs when the value of a resource or technology is expropriated by an unauthorized organization or individual. By externalizing part or all of the product development process, an innovating firm runs the risk of creating a competitor. This competitor could expropriate proprietary information and potentially beat the original innovator to market. Innovating firms have historically internalized product development because of the risk of opportunism.
However, the risk of opportunism can be reduced in three ways. The first is to break activities into tasks that are too discreet to contain any knowledge of value to a competitor. Out-sourcing only a small portion of the technical development process would make it possible to externalize tasks while minimizing the risk of opportunism. A second way to reduce the risk of externalizing activities is to out-source tasks to institutions that are not potential competitors. Institutions that are not commercial, like government labs or university facilities, should represent less risk than out-sourcing to other firms. Third, out-sourcing portions of the development process to spatially distributed facilities may reduce the risk of opportunism because there will be less chance that the different portions will be pieced back together and expropriated.
The above discussions lead to our first set of propositions:
P1: Firms will pursue a product development strategy of reducing time by conducting different tasks concurrently and/or different stages in parallel.
P2: Firms that are pursuing a product development strategy of reducing time will choose to out-source development activities rather than investing in specified assets.
P3: Firms will out-source segments of their product development in parts that are too small to reveal proprietary information.
P4: For certain aspects of product development firms will prefer to out-source to public research institutions than to private firms, because the risk of opportunism is lower.
PUBLIC POLICY CONSIDERATIONS
Regions that offer a favorable environment for the difficult process of new product development will attract biotechnology firms. The constraints of time, cost, and control over technology make it hard for firms to cross the gap between proving a technological concept and producing a commercial product. Policy makers can help create an environment that will foster the growth of biotechnology firms by offering financial incentives, R&D support, and mechanisms for protecting proprietary technology. Currently, Canada offers a variety of federal and provincial programs directed at attracting R&D activities. Research and development tax credits, venture capital tax credits, grants to projects involving pre-competitive R&D, support for industrial post-doctoral fellowships, direct financial assistance, and a variety other fiscal incentives are available to biotechnology firms in Canada.
The regulatory and approval process can have a significant impact of both the time and cost of commercializing a product. In the United States products are regulated by the Food and Drug Administration (FDA), and the Department of Agriculture and Environmental Protection Agency. Most of the products produced by the biotechnology industry are regulated by the FDA which results in substantial costs and delays in obtaining market approval. The total length of time can be up to seven years and R&D costs per new drug as high as $70m, (Daly, 1985). In contrast, Canada's regulatory process is faster and less expensive than approval by the FDA. Canada's standards, however, are accepted by most countries.
Based on the assumption that these policy initiatives are, at least to some extent, effective, and that firms will be attracted by favorable regulatory procedures, the following propositions are offered:
P5: Financial incentives are an effective way to attract biotechnology firms to a region.
P6: Firms will engage in product development in regions with favorable regulatory environments.
CASE STUDY RESEARCH
Four case studies were carried out with entrepreneurial firms in the biotechnology industry. Two of these cases are in-depth and are drawn from over a year of involvement with each of the firms. The first, Firm A, has been established in Canada for almost two years. The second, Firm B, is in the process of evaluating the advantages of operating in Canada. Both of these cases are based on frequent interaction with decision makes as well as structured interviews that help confirm and clarify the results of previous discussions. Both of the in-depth case studies involve the decisions to establish a considerable presence in Canada. The information from these cases is augmented by two shorter cases. These firms, C and D, are involved in out-sourcing to Canadian firms and institutions. These cases are based on structured interviews with key decision makers.
Firm A was founded in 1992 and has raised money through a combination of private and public offerings. The firm went public on the Alberta Stock Exchange in April 1993 and listed on the Toronto Stock Exchange in the summer of 1994. Firm A operates through a Canadian holding company with two U.S. wholly owned subsidiaries. The firm's corporate headquarters and executive management make up one of these subsidiaries. Firm A is committed to using joint ventures and collaboration instead of establishing in-house facilities, whenever possible. The firm has no in-house R&D facilities and out-sources all of its scientific work, including its basic research.
The majority of the firm's R&D is done in Canada. The Biomedical Research Center at the University of British Columbia and Canadian National Research Council facilities in Ottawa and Montreal undertake a large portion of the firm's basic research. The Vice President of Business Development emphasized that a reduced risk of losing proprietary information to a competitor is an important advantage of out-sourcing research to public institutions rather than private firms. These Canadian institutions, as well as a large compliment of technical firms, offer high quality and excellent value for the research dollars spent. Executives believe that R&D costs would be three times higher if this research was conducted in the U.S. These remarkable savings occur because Canadian labs offer services at a lower price than their U.S. counterparts and because of the tax incentives and matching funds available to Canadian firms undertaking R&D. For one project, Firm A's research dollars were matched, almost one to one, by the Canadian government.
Out-sourcing has also saved Firm A considerable time. The firm faces strong competition and is racing to market with both of its lead drugs. The V.P. of Business Development noted that: "Time to market is everything, it is probably more important than cost". He went on to explain that they had out-sourced the development of a certain carrier protein. It took 90 days and cost $35,000. The specialized equipment needed would have cost five to six million and it would have taken about 18 months to develop the protein in-house. This kind of time delay could be disastrous for the firm. In addition, the specialized facilities and staff would just sit until they were needed again. The firm's out-sourcing strategy allows them to undertake numerous projects simultaneously. Various projects are coordinated by the executive staff and the firm is in the process of hiring more scientists to oversee research done outside of the firm. Executives at Firm A estimate that, since formation, the firm has saved about 10 million dollars by out-sourcing R&D activities, primarily to Canadian firms and research institutions.
Firm B was founded in 1987. The firm has a research focus and most of its resources have been directed at proving and refining their product. The firm has entered the business development stage of its product development. Firm B's most pressing need is to raise capital to further develop and commercialize their product. Canada's investment climate is attractive because tax credits for investment in R&D intensive firms are available. Firm B first considered becoming a Canadian corporation in order to gain access to capital and take advantage of the more streamlined regulatory process. Initial inquiry suggests that they will be able to get the necessary permits to build a facility in British Columbia in much less time and at a significantly lower cost than in Washington State. In addition to these benefits, executives also anticipate significant cost savings through out-sourcing to Canadian firms and institutions.
Firm B faces an extensive research agenda. Their product has many potential applications that will require considerable testing. The firm does not anticipate developing internal testing capabilities. The efficacy and toxicity testing that has already been done has been out-sourced. Out-sourcing provides an independent assay, and allows the firm to benefit from association with reputable research institutions. Testing by highly respected individuals or medical research facilities gives Firm B, and its product, credibility. This benefit cannot be realized if activities are undertaken internally. Cost is also an important factor. Most of the R&D needed to commercialize Firm B's product requires laboratory facilities and staff that would be inappropriate for the firm to acquire.
Testing laboratories are working with samples, with no knowledge of how to make the substance. As a result, there is very little risk of having the technology expropriated by another firm or research institution. In this sense, product development is exceptionally well suited to out-sourcing. Firm B's need for capital has stalled their research agenda. Executives recognize the strength of Canada's R&D environment and are likely to out-source activities to Canadian firms or institutions, even if they raise capital from a source that does not require them to do research in Canada.
In general, Firm B does not try to undertake projects simultaneously. The outcome of one project will often affect the research agenda, so it is necessary to do work sequentially. Firm B is not under a great deal of pressure to get their product to market quickly. The founder and Director of Research suggested that the most effective product will prevail in the market, regardless of the order of market entry.
Most of Firm B's R&D involves further testing of their compound. The firm will do efficacy testing for a variety of applications and must conduct pre-clinical and clinical trials for applications requiring regulatory approval. For pharmaceutical applications, Canada's regulatory process is faster and less expensive than approval by the Federal Drug Administration (FDA) in the U.S. Canada's standards, however, are accepted by most countries. As a result, Firm B could sell its product in Canada and most of the world while working on FDA approval. Firm B plans to take advantage of Canada's streamlined regulatory process for pharmaceutical applications of its product.
Firm C is a small but well established pharmaceutical firm that focuses on developing new biotechnology products related to a single disease. They have a significant investment in laboratory facilities but contract out research that does not fall within their area of expertise. When out-sourcing key research projects, they consider the expertise and reputation at an institution. Firm C recently awarded a contract to a Canadian institution that had the necessary qualifications. Although cost was not an initial consideration, the Canadian institute presented a very low bid for the project. This impressed the Director of Research who indicated that cost savings might be a reason to undertake future projects in Canada. Decision makers at Firm C have also been pleased with the cost and quality of clinical testing done by several different Canadian firms. While they do not anticipate taking advantage of Canada's favorable regulatory or investment climate, the Director of Research expects to continue and probably expand their out-sourcing activities in Canada.
Firm D is a relatively small biotechnology firm with extensive and expensive internal facilities. Firm D is currently out-sourcing to two Canadian firms. They are working on projects that are outside of their expertise. Cost is the main reason for working with one of the Canadian firms. In the other case, the Canadian firm is working in an area of complimentary technology. It makes sense for Firm D to team up with this Canadian partner and advance the research agendas of both firms. Because Firm D is in the process of gaining FDA approval for their lead product, they do not anticipate taking advantage of Canada's favorable regulatory environment.
Currently, the Director of Business Development is most interested in expanding involvement in Canada to gain access to capital. Like Firm B, this firm is interested in raising money in Canada. Although they have the facilities to meet most of their R&D needs in-house, they would be willing to incorporate in Canada and out-source to Canadian firms and institutions, if it is a prerequisite for funding. Firm D would then use its own facilities to do contract work for other firms.
CONCLUSIONS AND IMPLICATIONS
This paper has used qualitative data to evaluate research propositions and explore the relationship between regional policies and product development activities. The results of the case studies provide mixed support for the propositions. Firm A and C are both engaged in strategy of minimizing the product development time by undertaking activities in parallel. Firm B is not pursuing this strategy as there are no real capable competitors for the particular market niche. In addition, due to the nature of their product and their stage of product development, it is necessary to do most tasks sequentially. It appears that, when reducing time to market is important and when it is possible, firms will undertake activities in parallel.
A major aspect of this research was to investigate the degree to which biotechnology firms are out-sourcing product development activities. Firm A is proactive in utilizing this strategy and currently out-sources all of its R&D functions, to the extent that it has no internal capacity. This approach has allowed them to minimize investment in specified assets. Firm B is currently out-sourcing it's product testing activities although some further product development may be done internally. Firm's C and D are out-sourcing small portions of product development, but for the most part are choosing to undertake research activities internally as they already have made large investments in research assets. Care is taken by all firms to avoid out-sourcing proprietary information to a potential competitor.
The propositions aimed at investigating the effect of regional policies also received mixed support. All of the cases provided strong evidence that firms prefer to out-source research activities to public non-competitive institutions. There is no question that the firms in our sample would have been much more cautious out-sourcing product development activities to private firms. It should also be noted that the type of public research facilities offered in Canada would be extremely expensive for a single firm to replicate.
Our second policy proposition was concerned with the effect of financial incentives on bringing research activities to a region. This proposition received strong support from our data. The costs associated with R&D are significant, and government matching funds and/or tax incentives help stretch scarce research dollars. R&D investment incentives also appear to be important. Firm A has raised the capital it needs in Canada. Both firms B and D are trying to raise money in Canada, where the investment climate is more favorable to biotechnology firms.
The issue of Canada's favorable regulatory environment was not as critical as expected. Only one of the firms, firm B, stated that this was an important consideration for locating in Canada. The other case study firms were pursuing FDA approval and consequently, derived no direct benefit from Canada's streamlined regulatory process. It is likely, however, that some of the savings they realized by out-sourcing to Canada are related to the regulatory process. Especially with respect to animal testing for clinical trials, lower bureaucratic overhead is likely to reduce the cost of testing. This may help explain why Canadian testing firms can often underbid their U.S. counterparts.
In conclusion, the cases in this study support our contention that regional policies can attract the research activities of firms in the biotechnology industry. Regions that offer public research institutions, financial incentives, and a favorable regulatory environment provide significant location advantages. Advantages can be realized both by firms moving to Canada and firms out-sourcing portions of their product development process to Canadian firms and institutions.
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1 For a recent discussion of first mover advantages and capable competitors see Hill et. al., 1993.
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