Corporate Venture Capital at Elililly

9-806-092

REV: J U LY 31, 2007

RICHARDHAMERMESHRON LAUFER

DAVID LANE

Corporate Venture Capital at EliLilly

In October 2005, Darren Carroll was completing his second month as senior managing directorofNewVenturesatEliLillyandCompany(Lilly).Inthisrole,Carrollwasinchargeoftwodistinctgroups within the corporation. One was Lilly’s corporate venture capital (CVC) group, LillyVentures, an evergreen fund with a capital pool of $175 million that had been investing since 2001inbiotechnology, healthcare IT, and medical device start-up companies. The other wasLillyAccelerators, which since 2000 had been incubating business ideas developed by Lilly employeesthathadthepotentialtotransformvariouselementsofthepharmaceuticalindustry.CarrollhadbeenassessingtheoveralleffectivenessofLillyVenturestodate,whetheritwassufficientlyalignedwithLilly’s overall strategy, and any changes needed to make Lilly Ventures moreeffective.

Atthesametime,Carrollwasreviewingaparticularlyinteresting,andpotentiallyproblematic,Series A investment that was being proposed by Lilly Ventures. The possible investment, in anearly-stage chemistry-engine technology company called Protagonist, located in Brisbane,Australia,representedamajoropportunity,butwouldbeunusualinmanyrespects.Carrollexplained:

One of the great advantages of being a corporate venture capital fund is that we are abletomakeinvestmentsthatareearlierstagethanregularVCswouldbewillingtomake.Inthiscase, the company is probably three years away from starting its first clinical trial. That, plusitslocation, is a turnoff for U.S. VCfirms.

As a matter of policy, we only invest as part of a syndicate. Since we have begun to taketheleadinthisinvestment,severalAustralianVCfirmshavesignedup.Butsofarwehavebeenunable to get a top-tier U.S. VC firm to invest. Should we really continue to pursue a dealthatcan’t attract a U.S.investor?

Corporate Venture Capital

IntheUnitedStates,corporateventuringhistoricallyshowedstrongcyclicality.Betweenthelate1960suntiltheoilshockof1973,over25%ofFortune500firmssetupdivisionsthatmimickedindependent venture capital firms. However, poor returns and the belt tightening induced by theoilcrisissharplycurtailedmostcorporateventureinvesting.Asecondwaveofcorporateventuringarose during the 1980s. By 1986, corporate funds managed $2 billion (12%) of the total pool ofventure

ProfessorRichardHamermesh,Dr.RonLaufer,andGlobalResearchGroupSeniorResearcherDavidLanepreparedthiscase.HBScasesaredevelopedsolelyasthebasisforclassdiscussion.Casesarenotintendedtoserveasendorsements,sourcesofprimarydata,orillustrationsofeffectiveorineffectivemanagement.

Copyright © 2006, 2007 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call1-800-545-7685,writeHarvardBusinessSchoolPublishing,Boston,MA02163,orgoto stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic,mechanical,photocopying,recording,orotherwise—withoutthepermissionofHarvardBusinessSchool.

capital. At this time, high-tech and pharmaceutical firms were the leading corporate investors,thoughthe1987stockmarketcrashdriedupthedemandforIPOs.Thethirdwaveofcorporateventuringrodethehigh-techbubbleandequitiesbullmarketofthelate1990s.1Oneconservativeestimate put corporate venture capital at $8 billion in 1999, a 20-fold increase over 16 years.2 Muchofthisevaporatedinthetechnologyandequitiesslumpof2001–2002,asAccenture,Dell,Level3,andOracle, among others, sold off their venture arms.3 Of the $21.7 billion in venture capital investedin2005,4 corporate venturing accounted for $3.1 billion (14%), and corporate venture investments inthelife sciences amounted to $1.1billion.5

Whilecyclicalitytypifiedcorporateventureinvestingingeneral—robustwhentheparentwashealthy,curtailedwhentheparentailed—thepharmaceuticalindustryresistedthetemptationtoenterandexittheventurebusinessasapack.Instead,differentpharmaceuticalfirmsatdifferenttimesreachedthepointatwhichexternalandinternalenvironmentssupportedthelaunchofaventurefund.TheoldestactivecorporateventurefundinlifescienceswastheJohnsonJohnsonDevelopmentCorporation(JJDC),establishedin1973.Thesecond-oldestactiveinvestmentgroup,S.R.One, was over a decade younger. Launched in 1985 after several years of fund-of-fundsinvesting,thisinvestmentarmofSmithKlineBeechamgainedearlysuccesswithitsinvestmentinAmgenandbecame a model that other corporate fundsemulated.

Atthesametime,CVCsinthepharmaceuticalindustrystillreliedfortheirexistenceonsupportfromseniorcorporatemanagement,whichcouldwaxandwanewithcorporatepriorities,earningsprospects,andpersonnelchangesatthetop.Inaddition,thereportingrelationshipsofCVCarmsvariedgreatly—reportingtotheofficesoftheCEO,CFO,orBusinessDevelopment,forexample.Elaine Jones, a former vice president at S.R.One, asserted that having a champion who is very highintheorganizationwasakeysuccessfactorforanyCVC:

Someone must be willing to invest in corporate venturing for years, because it takesseveralyears to see results. This person needs to have a long view, not come to check in by thequarter.Itstartswithseniorleaderswhoseethisasadifferentfacetofbusinessdevelopmentwhichmakesmoneyforthecorporation.Asyourmanagementchanges,peopleandneedschange,and you need to continue demonstrating that you add value. There will always be peoplethatsee CVC as an unnecessary end of the tail of thedog.

Unlike stand-alone venture capital (VC) firms, which funded start-ups purely in the expectationoffinancial gain through their eventual sale or IPO, corporations set up venture capital armsprimarilytonurtureanddevelopstart-upbusinessesfortheirparentcompany.6Ingeneral,thepayofftotheparent was strategic and typically involved either access to innovation or support for the viabilityofthe parent’s business objectives. Among technology companies in particular, corporateventureinvestments helped create an “ecosystem” that helped broaden and deepen the market fortheparent’sproducts.Chemicalandpharmaceuticalcompaniesusedventureinvestmentsprimarilyto

1Paul A. Gompers, “Corporations and the Financing of Innovation: The Corporate Venturing Experience,” EconomicReview—The Federal Reserve Bank of Atlanta, 87:4 (2002):1–6.

2AssetalternativesdatacitedinPaulA.Gompers,“CorporationsandtheFinancingofInnovation:TheCorporateVenturingExperience,” Economic Review—The Federal Reserve Bank of Atlanta, 87:4 (2002):6–7.

3Felda Hardymon and Ann Leamon, “SAIF: May 2004,” HBS Case No. 805-091 (Boston: Harvard Business SchoolPublishing,2005), p.5.

4 accessed February 1, 2006.

5Casewriter calculation from Thomson Venture Expertdata.

6See Julian Birkinshaw, “The Secret Diary of Corporate Venturing,” Business Strategy Review, 16: 2 (Summer 2005):1–24.

learn about, license, or acquire innovative new compounds, processes, and intellectual property(IP).Theirinvestmentscouldtaketheformofpureequityinvestmentsorequityplusadditionalrightssuch as licensing agreements. Alternatively, corporate venture investing could be partofcollaborationagreementsbetweenfirmstocooperateinthedevelopment,marketing,andsaleofproducts that neither partner could producealone.7

Asaresult,CVCdifferedinseveralwaysfromthestereotypicalVCinvestment.CVCinvestorsnormally offered start-ups more complementary assets—physical, knowledge based,andintangible—than a VC could. Theoretically, CVCs could invest in companies regardless oftheirdevelopmentstage,whereasaVCwouldtrytotimeitsexitsaroundthelifecycleofitsfundortheraisingofanewfund.8Notpurelymotivatedbyfinancialreturns,CVCswerelessconstrainedbyissuesofvaluation.Forthesamereason,corporationswereoftenlessemphaticthanVCsaboutmaximizing a start-up’s financial discipline. More critically, a CVC’s investing interests couldbeviewedaslessalignedwithitsstart-up’sandmorefocusedoninformationgathering,hedgingtheparentcompany’sbets,andevenasstrategicdenialofanopportunitytoarival.Asoneaccountputit,CVCswere“historicallyregardedasatbest,fickle,andatworst,misguided.”9Recruitingandretention were additional challenges for CVCs. Few VCs were eager to forgo a share ofinvestingreturnsfortherigidityoflowercorporatepayscales,andthemostsuccessfulcorporateinvestorsoften left for privateVC.10

For start-up companies, corporate venturing offered the backing of a large company, backingthatpotentially extended beyond an injection of capital to include access to experienced managementandsectoralexpertise,aswellasaccesstoR&D,marketing,anddistributionchannels.Moreover,CVCrecipients were well placed to receive subsequent funding from third parties, often on the basis ofthevalidation created by the earlier corporate investment—the halo effect. In addition, acorporateinvestorusuallycreatedaclearexitpathforstart-upcompanies.11However,start-upsfearedthepotentiallossofmanagementcontrolthatevenalightcorporateembracecouldbring.TheyalsoworriedthatanyIPsharingcouldcreateaformidablecompetitor.Anotherkeyconcernwasthathaving one corporate investor on board could scare other corporations away frombusinessdevelopment,collaboration,orM&Adealswiththestart-up.Asoneexpertputit:

Entrepreneurs were limited by this structure because . . . they were forced tosacrificebreadthofavailableresources.Inaddition,early-stageentrepreneurswereoftenconcernedaboutprotectingtheirintellectualpropertyandwantedtoavoidalliancesthatcouldthreatentheir position. For example, a small high-technology company in a precariousfinancialsituation might be reluctant to approach IBM or Sony directly for funding. Therefore, theverycompaniesinwhichthesecorporationswantedtoinvestwereusuallytheonesthatnevermade it to theirdoorsteps.12

7See Lisa Bushrod, “Corporate Venturing: Different Models and Their Applications,” European Venture Capital & PrivateEquityJournal, September 1, 2005, p. 1. Available from ProQuest, ABI/Inform, accessed December 15,2005.

8Henry Chesbrough, “Designing Corporate Ventures in the Shadow of Private Venture Capital,” CaliforniaManagementReview, 42:3 (Spring 2000):38–41.

9Hardymon and Leamon, p. 5.

10Hardymon and Leamon, p. 6.

11See Edward Cartin, “Corporate Venturing: A Financing Cinderella,” Accountancy Ireland, 37: 3 (June 2005):30–31.

12Paul A. Gompers, “Corporations and the Financing of Innovation: The Corporate Venturing Experience,” EconomicReview—The Federal Reserve Bank of Atlanta, 87:4 (2002):2.

Eli Lilly andCompany

EliLillyandCompanywasfoundedin1876byitsnamesake,acolonelintheUnionArmyandpharmaceuticalchemistbytraining.Drivenbyafrustrationwiththepoorlypreparedandoftenineffective medicines of his time, Colonel Lilly committed himself to basing his new company onthebestscienceoftheday,developingonlymedicinesthatwouldbedispensedatthesuggestionofaphysician and manufacturing products of the highest possible quality. With a staff of three,includingadrugcompounder,abottlerandfinisher,andhis14-year-oldsonJosiah,hesetupthecompanyindowntownIndianapolis,onlyafewblocksawayfromthepresent-daylocationofthecompany’sglobalheadquarters.

Overthenext129years,EliLillyandCompanyplayedakeyroleinimprovinghumanlongevityand quality of life around the world. In 1923, Lilly introduced Iletin, the first commerciallyavailableinsulinproductforthetreatmentofinsulin-dependentdiabetesmellitus(IDDM).PriortotheLillycollaboration with Banting and Best, the discoverers of insulin, the only effective method toprolongthe life of children diagnosed with IDDM was a caloric-negative diet, effectively starving thechildrentodeath.

Fromthe1940s,Lillybuiltanameforitselfintheanti-infectivearea.Startingwiththemassproduction of penicillin, the company moved to introduce products such asVancomycin,Erythromycin, Keflex®, and Ceclor®, the world’s top-selling oral antibiotic in the 1970s. In the1980sand 1990s, Lilly became a neuroscience powerhouse, introducing a new class ofantidepressiontreatment with Prozac®, as well as Zyprexa® for the treatment ofschizophrenia.

Prozac was a particularly important drug to Lilly and became a cultural totem, effectivelymarking the first time prescription drugs could safely and effectively be used to improve mood.Theimpact of Prozac was both positive and negative: the drug had brought the company about $2billionannuallyandhelpedquadruplethecompany’sstockbetween1993and1998,butitalsocreatedastrategiccrisiswhenitwentoffpatentin2001.WhileProzacanditsrelativescontinuedtogenerateover$500millionin2004salesforLilly,itsgoingoffpatentforcedLillytorolloutdrugsandstrategiesthatcouldsustainthecompanythroughtheearningstroughthatfollowedtheonsetofcompetition fromgenerics.

Over the years, Lilly added medical devices, diagnostics, animal health, even cosmeticsbusinessesbutduringthe1990srefocusedonitspharmaceuticalcore,spinningoffmanyofitsmedicaldeviceassetstoformGuidantin1994,sellingothernoncorebusinessunits,andretainingasaseparatedivisiononlyitsanimalhealthbusinessunit,Elanco.Bytheendof2004,Lillyhadsalesinover140countries, amounting to a record $14 billion (see Exhibit 1). Its lead product, Zyprexa®,reachedblockbusterstatuswithworldwidesalesofcloseto$4.5billion,followedbysignificantproductsintheareasofoncology,endocrinology,andwomen’shealth.KeepingColonelLilly’scommitmentto“the best science of the day,” the company reinvested over 19% of its sales in R&D through anetworkof science facilities in nine countries, with clinical research conducted in over 60countries.

Forming the e.Lilly and Lilly BioVenturesFunds

In the 1980s and early 1990s, Lilly began making equity investments in start-up companies aspartof its business development transactions. Some of those investments—initially conceived of as justaminorcomponentofalargerscientificcollaborationbetweenLillyandsmallbiotechcompanies—turned into significant moneymakers. Ron Henriksen, the architect of most of these deals,describedhow Lilly developed its initial interest in biotechnology partnerships: “Ever since the late 1970s,Lilly

wasconcernedthattherewouldnotbeenoughanimal-derivedinsulintosupplythegrowingnumberof diabetic patients. That led to the first significant business development deal between alargepharmaceuticalfirmandasmallbiotech—thelicensingofthetechnologyforhumanrecombinantinsulin from Genentech.” By the late 1980s, Henriksen was Lilly’s director of businessdevelopment,reporting directly to the CFO. In this role, he started making equity investments in start-upcompanies as part of licensing deals with them. As Henriksenrecalled:

Thedriversweretwofold.Gettingaccesstotechnologieswaskey.IfitwasareallygoodcompanyinanareaLillywasinterestedin,Iwantedtogetinfirst.Lillywasheldinhighesteem;companieswantedLilly’svalidationasaninvestor.Wealsowantedtomakemoney.Theconceptwastorunanevergreenfundofasort,sowewouldnothavetogobacktothecorporationforeverynewdeal,butthekeydriverwastogetaproductortechnologyintoLilly.Generallyweinvestedalone,sometimespayingapremium,butalwaysaspartofabusiness development deal. Sometimes the collaboration would fail, but we still mademoney.For example, we invested in Athena Neurosciences, but the science was too early and Lillydidnot get a product out of it. But we made over 35%IRR.

Twenty-sixofHenriksen’s50dealsincludedanequityinvestmentcomponent.Atthetime,Lillyalsoinvestedasalimitedpartnerintwoventurefunds,oneoneachU.S.coast.SaidHenriksen,“Itwas a way to watch how venture capitalists worked, to sit at their meetings and become a memberoftheclub.Wedidlearnstufffromtheseguys.Intheendwewereasgood,andweconcludedthatremaining an LP would be adistraction.”

But such successes did not lead Lilly toward more intense corporate venture investing, nor diditraisethefirm’sappetitetoinvestinprivateventurecapitalfunds.Infact,Lillyrepeatedlydeclinedinvitations to invest as a limited partner in life science venture funds during the late 1990s.Accordingto Chuck Schalliol, who headed Lilly’s corporate finance and investment banking departmentduringthemid-1990s:“VCsoftenapproachedLilly,askingustoinvestasalimitedpartnerintheirfunds.TheLillynamewouldlendtheirfundscredibilityandprestige,whilewewerepromisedaccesstotheirdealflow.ButourpolicywasthatLillyshouldonlyinvestforstrategicadvantage,notpurelyfor financial return. We didn’t need access to VCs and the financial world, and we could get accesstothebiotechcompaniesourselvesifthatwereimportanttous.”

In2000,however,Lillylaunchedaninternalcorporateexperiment.Inresponsetothegrowingimportance of the Internet and wireless technologies, the company established a small newdivisiondubbede.Lilly.Thecharterofe.Lillywastoexperimentwithnewtechnologies,newbusinessmodels,andnewpracticesthatmightultimatelyhaveasignificantimpactonthepharmaceuticalindustry.Thedivision’sobjectiveswerebroad,rangingfrominfluencingthediscoveryanddevelopmentofnewdrugsontheonehand,tonewwaystomarketandsellthemontheother.Tothisend,e.LillywouldhusbandideasoriginatingwithintheLillyorganizationorelsewhere,initiatecollaborationsbetween Lilly business units and external partners, and manage its own venture capitalfund.Schalliol argued that e.Lilly needed to function as much as a pure VC as possible. At the sametime,hestated,“Wesaidthatwe’donlyinvestifitgaveusaccesstotechnologyweviewedasinterestingtoLillyResearchLabsorourbusinessunits.Ineffect,weexpandedbusinessdevelopmentactivities.”

Withanallocationof$50millionandaninternallyrecruitedstaff,thee.Lillyventurefundwaslaunched in January 2001 with a mandate to focus its investments in four areas:“open-sourceinnovation”—the use of Internet-based networks to foster scientific innovation from aroundtheworld;e-ClinicalTrialsandDevelopment—leveragingsponsor/investigator/patientnetworkstoreduce the time and cost of clinical trials; “Physician Connectivity”—multichannel,patient-physicianrelationships;and“thee-Patient”—deliveringpatientinformationatthepointofcare.

At roughly the same time, another venture fund concept emerged from Lilly’s corporatestrategyandbusinessdevelopmentgroup.Thiswasalsoinresponsetoatechnologicalrevolution,onlyofadifferent nature. Over the course of the late 1990s, many technologies that were tightly connectedtothedrugdiscoveryanddevelopmentprocesshelpedfomenta“genomicrevolution.”Backedbyventurecapital,manynewcompanieswereformedtotakeadvantageoftheabundanceofnewlydiscovered biological data and groundbreaking platforms and capabilities. Many of thesecompanieslooked up to leaders of the biotech industry such as Amgen and Millennium Pharmaceuticals,whichhadstartedasventure-backedstart-upcompaniesandwerenowontheirwaytobecomingfullyintegrated pharmaceuticalcompanies.

As the number and importance of these biotech start-ups grew significantly, differentpeoplewithin the Lilly organization argued that perhaps it was time for large pharmaceutical companiestobemoreengagedwiththem,notjustascollaboratorsorasthepotentialacquirerofanendproduct,but as a constructive influence in their early days. As Lilly employees watched the trajectories ofsuchfirms,itoftenseemedthatsmallbiotechscouldbenefitgreatlyiftheyhadaccesstotheorganizationalmemory,discipline,anddeepcommercialunderstandingresidentinlarge,maturepharmaceuticalcompanies.Acorporateventurecapitalfund,runoutofLilly’scorporatestrategyandbusinessdevelopmentgroup,wasseenasanappropriatevehicletoprovidethataccess.SchalliolproposedthatifLillychosetodocorporateventuring,“Let’sgetcompetitiveadvantageoutofitbygoingitalone, not as a limited partner in the same funds as our majorcompetitors.”

Launched in September 2001, Lilly BioVentures was allocated $75 million and was staffedinitiallywithinternalrecruits,primarilyfromLilly’sM&Adepartment.Lateron,juniorstaffwererecruitedfrom outside Lilly. The team was responsible for the generation of deal flow, due diligence, closingofdeals, and portfolio management. Its investment focus was broadly around two key areas:“enablingtechnologies”—tools and platforms that could enhance the drug discovery and developmentprocess;and “horizon therapies”—emerging and novel therapies that lay beyond the boundaries ofproductscurrently being tested and marketed by the biopharmaceutical industry. The mission ofLillyBioVentures was to make early-stage to expansion-stage investments as part of a syndicate ofventureinvestorsinreturnforanequitystakeaswellasboardorobserverseats.Theteamalsoworkedtoleveragethelargecorporateorganizationbehindthem.LillyVenturesexpectedthisleveragetocreatevalue in three ways—as an additional source for deal flow through the network of thousands ofLillyscientists and businesspeople, as a source of expertise for the purpose of due diligence, and finally,asa resource for the benefit of portfoliocompanies.

The BioVentures fund had an investment committee of three, including Schalliol, who headedtheBioVenturesfund,Lilly’sheadofresearchstrategy,andtheCFOofLilly’sresearchlabs.Anytwomemberscouldcommittoaventureinvestmentofupto$5millionwithoutfurtherapprovals.

LillyBioVenturesallowedLillyrepresentativestogetafirstlookatcompaniesearlierthanLillymightotherwiseseethemaspotentialbusinessdevelopmentpartners.Accordingtoonemanager,theearly opportunity to enter a relationship with a start-up also gave Lilly a way of identifyingpossibletechnicalsnagsbeforetheybecametoosignificantforthestart-uptofixlater.Thegoodwillthatresulted from such assistance helped position Lilly as a relationship-based investor and, itwashoped, provided Lilly with an advantage in case of a bidding war among top pharmaceutical firms,asituationthatfrequentlydevelopedoverdesirableacquisitiontargetsorcollaborationpartners.

YetLillyBioVentureswasnotsimplyanextensionofthebusinessdevelopmentoffice,Schalliolemphasized: “Our goal was to make money, to beat the corporate hurdle rate. Wedescribedourselvesasfinancialinvestorsinareasofstrategicinterest.Wedecidedtobeasmuchlikearealventurefundaspossible.Evenifacompanyhadgoodtechnology,we’dreferittoourlicensingandbusiness development people if it didn’t look like it would make money forus.”

The First FourYears

Lilly BioVentures invested in 10 companies in its first four years through 2005 (see Exhibit 2).AllLilly BioVentures investments were for equity in the form of preferred shares; there were no tie-inorlicensingcomponentstoitsdeals.LillyBioVenturesalwaysinvestedaspartofasyndicate,neverassoleinvestor.Therewereseveralreasonsforthis.First,itallowedLillyBioVenturestobenefitfromthefundsofotherinvestors.Second,itbroughtadditionalexpertisetothestart-upandtothedeal.Third,syndicateparticipationtendedtoenhancedealflow,asLillywouldsometimesbeinvitedtoinvest with a syndicate member in one or more of its deals. Syndicate members were usuallytop-tierfirms,preferablyintheUnitedStates,wheretheliquidityeventwasmostlikelytooccur.

Lilly BioVentures also took board or observer seats in each of its companies. Though oneprincipalnotedthatportfoliocompaniessometimesinitiallyobjected,fearingthattheycouldnotthereaftercollaboratewithorselltoaLillycompetitor,“Inresponse,we’dexplainthattheboardseatswillbeoccupiedbyourinvestmentprofessionalorinvestmentcommitteemembers.”Thatis,LillyBioVentureswouldestablishaclear“Chinesewall”betweentheportfoliocompanyandtherestofLilly. Unusually for a CVC, Lilly Ventures was not averse to leading an investment round and infacthad done so for four of its 10companies.

Through this process, Schalliol noted, “We found that our analysis was often more thoroughthanthatofourco-investors.Wewereproudwhenaventurecapitalisttoldus,‘Wedon’tlikecorporateventure funds, but we’ll work with you.’ I’m proud of our investment process and that we run it likea real venturefund.”

Between 2002 and 2004, the e.Lilly venture fund was merged into Lilly BioVentures, with thejointgroupoperatingunderthenameLillyVentures.Inaddition,thegroupwasallocatedanadditional

$50 million for investments in medical devices. By 2005, Lilly Ventures had $175 millionundermanagement, with 17 portfolio companies and a team consisting of its managing director,fourprincipals, and two associates. However, with its growth, and especially with the entry intothemedical devices area, the group had to resolve internal questions regarding its fit with the rest oftheLillyorganization.

Mike Gutch, a Lilly Ventures associate, elaborated in conceptual terms how the group fitinternally withinLilly:

Corporateventurecapitalcanbeseenasexclusivelystrategic,asafrontendforfuturebusinessdevelopment—toacquiretechnologiesthattheparentcompanyneeds.Elsewhere,corporateventurecapitalcanhelpthecompanyasanagentofproductcommercializationorcanactasaninternalserviceorganizationfortheparentcompany.LillyVenturesisnotlikethis.Wehaveadifferentmandate.Weexploreemergenttechnologiesandthosethatinsomecases are contrarian to Lilly’s current business mix. It might be too early a technology,orsimplyahedgeoradifferentapproachfromwhatthecorporationisdoing.MyperspectiveisthatweshouldfocusprimarilyontheareasLillyworkson,includingneurologicaldiseases,metabolic diseases, and cancer, but be open to looking at other therapeutics spacesandtechnologies on a selectivebasis.

Schalliol put it morepragmatically:

I felt we needed to have a higher standard than typical corporate venturing required.Dealswill fail early and succeed late. I wanted to avoid early failures to validate our model,becausethere was pressure within the firm. We had to resist the desire of some senior people tomakeusadirectarmofbusinessdevelopmentortransferthedollarstotheR&Dbudget.Alotofit

amounted to researchers saying that they could use the money allocated to us moreeffectivelyifitwaspartoftheirownR&Dbudget,misunderstandingthatwewereabalancesheetitem,not a cost on the income statement like R&D. Our position was that Lilly Ventures will getourscientists more access and leverage than they could on their own given that they could notgetthe same dollars for direct operatingexpense.

The compensation system was another chronic challenge, saidSchalliol:

We had the choice of being separate from Lilly or part of Lilly’s system. We chose thelatter,butthatcreatedincentiveproblems.Unlikeventurecapitalpartnerships,wecouldn’tgivepeople a piece of the traditional carry. We purchased a survey that found that wepaidcompetitively only at the level of a VC associate or vice president level, below the equivalentofVCpartner.Ontheotherhand,LillyofferedsomethingsaVCcouldn’toffer,likeimmediatebonuses at the end of a year and stock options, whereas VCs had to wait for their deals tocometo fruition. The overall package was not hugely disadvantageous especially at the morejuniorlevels,andwedidrecruitexcellentyoungerpeoplefromoutsideLilly.

Bymid-2005,LillyVenturesexperiencedseveraldeparturesfromitssmallteam.Schalliollefttohead a local initiative to promote the development of the life science industry in central IndianaandlaterwasaskedbyIndiana’sgovernortoserveastheheadofthestateOfficeofManagementandBudget.Hissuccessorasmanagingdirector,DominicColangelo,leftforaseniormanagementrolewithapublicbiotechnologycompany,andEdSeguine,oneofthefund’sprincipals,lefttobecomethe CEO of one of the healthcare IT portfoliocompanies.

Following Colangelo’s departure, Darren Carroll took over as head of Lilly Ventures, reportingtothe Lilly vice president of business development. Following service as Lilly’s U.S. attorney forProzac,Carrollhadbuiltseveralbusinesses,eachofwhichusedtheInternettoinnovateinthelifesciences.TheseincludedInnoCentive,anonlineresearchcommunitythatwasalsoLilly’sfirste-business.

Inhisnewrole,CarrollmovedquicklytosurveythecorporateviewofLilly’sventureactivities.Thefeedbackhereceivedwasthat,despitestrongsupportfromthetopforcorporateventuring,Lilly’s CVC would need to communicate more frequently and more effectively with theLillycommunity, much of which believed that Lilly Ventures overly emphasized its external face andwasnotsufficientlyintouchwiththestrategicneedsofthecompany.Inaddition,itwasobvioustoCarrollthatthecompensationsystemwasnotgoingtochangeinordertomimictheprivateVCmodel.Henoted:“Whilesomeviewdeparturesasinherentlydestabilizing,inmyopinionitcreatesan opportunity forchange.”

WiththeaddedresponsibilityforLillyAccelerators,CarrollchosetocontinueSchalliol’sdistinctionbetweenactingwiththedisciplineofaventurefirmversusservingasanagentofLillybusiness development. “We’re not here to get an option on a firm,” Carroll stated. “BothLillyAcceleratorsandLillyVenturesareexpectedtobeprotectingourflank,sinceothersarefocusedonLilly’sbottomline.”Asanotherprincipalputit,“Weneedstrategicalignment—butnotidentity—with Lilly’s strategic development and research strategy. Any potential investment must beastrategicfitwithLillyfirst.”Carrollagreed:“IfwehadfinancialreturnsbutnoalignmentwithLillystrategic goals, we’d be shut down. There are two currencies to our success, cash and alignment.Onewaytorepayalignmentcurrencyiswithcommunication.You’vegottotellyourcorporationwhatyou aredoing.”

The ProtagonistDecision

The Lilly Ventures team had noticed that VCs since the mid-1990s often were forced to carrytheirearly-stage U.S. biotech investments longer, prior to IPO or sale. In some instances, VCswereexpected to buy additional shares at the IPO stage in support of their portfolio company. At thesametime,themarketseemedtonolongerrewardlonger-terminvestments.ExplainedGutch:

Thebuysidehassimplygottensmarteraboutbiotechnology.Theyarenolongerbuyingintofirmsinthefirstorsecondphaseofpharmaceuticaldevelopment,wheresignificantriskremains. Nowadays, every buy-side firm uses professionals who are medical doctorsandPh.D. scientists to evaluate companies and their products. They want firms already in Phase3ofdevelopment,sincethislimitstheirrisk.Yetpre-IPOvaluesforcompaniesatthisstageofdevelopment have declined from previousyears.

Thequestionbecomeshowtomakemoneyinvestinginearly-stagebiotechstart-ups.Theansweristobecapitalefficient,andwecandothatintwoways:first,byfindingcompanieswherelaborandfacilitiescostsarelowerthanBostonandCalifornia,andsecond,byfindingcompanies and technologies that are more advanced prior to the Series Ainvestment.

While on sabbatical at an Australian business school in late 2004, one Lilly Ventures principaltookthetimetolearnaboutthelocalVCandbiotechnologymarkets.Throughthoseefforts,hewasintroduced to a local firm called Protagonist. Established by Mark Smythe in 2002 inBrisbane,Protagonist had developed a platform for “rational drugdesign.”