Substitutes and complements in life sciences
Life sciences strategy
As always, if you or someone you know has a great idea or company in life sciences, Axial would be excited to get to know you and possibly invest in your vision and company.
Strategy in life sciences is often focused on new technologies or discoveries - investing in them and hoping that creates enough value to get approval, go public, or get bought out. This makes sense given that high levels of technical risk upfront for most companies in the field. This high activation energy for most companies in life sciences doesn’t allow for too much deep thinking about business models. Getting just experiments to work is a big win. Afterwards, the markets in life sciences are self-evident and companies can execute a traditional model following the same path as others. With so much work done on the science, trying to figure out how to build a different type of business is often not feasible. As upfront technical risks in some spots of life sciences goes down or at least is more easily identifiable, more creativity in business model design is possible.
A powerful framework for software businesses introduced almost 20 years ago by Joel Spolsky called “Commoditize Your Complement” (although he never explicitly used the term) is becoming more useful for life sciences. An introductory microeconomics class in either high school or college introduces the idea of substitutes and complements. A substitute is a product that one would buy in place of a similar one - an example in life sciences, is a generic drug versus a newly approved one. A complement is a product one buys bundled with another one - in life sciences, paying for a hospital bed often comes with other expenses like an ambulance trip. Every market has substitutes and complements. Most companies solely focus on substitutes; often the competition. Consultants are paid and powerpoints are made to understand how a company doesn’t fall behind the competition. A great way to get ahead is to focus on complements - they are non-competitive most of the time and can build powerful moats that are historically insurmountable by others. Ultimately, the basic strategy with this framework is that demand for a product increases when its complements’ price decreases. One caveat is that this model does not work for markets with perfect substitutes (i.e. electricity, gold bars).
Key points (snippets so you don’t have to read the whole thing if you don’t have the time right now):
In order to commoditize a complement, companies should look for markets with sellers that are commoditized or could be - this could be determined by the nature of the underlying technology, how products are distributed, or how fragmented the supply side is.
Traditionally, entrepreneurs try to find markets that are very large where customers are probably being over-charged - focusing too much on being a substitute, say outcompeting the competition. A different way, that could be just as effective or maybe more so, is to approach markets where a complement could be commoditized.
Essentially, a company that makes a complement abundant has the opportunity to sell something scarce and create a “desert of profitability around [the] company.” Life sciences companies have a lot of leverage with IP and new ways of distribution to easily implement this type of model. Some of companies like Illumina and Express Scripts are doing it right now to their benefit. Long-term what happens in markets with a dominant player that has commoditized their complement(s), companies elsewhere in the supply chain have too low margins and maybe are too small to invest in their own IP or distribution capabilities to compete in any way. This enables an enduring, large business in life sciences.
There is a list of 8 examples of this framework playing out in life sciences: Adimab, Illumina, Benchling, Novartis, Twist Bioscience, Express Scripts, Parker Institute for Cancer Immunotherapy, and Deerfield.
Markets are driven by supply and demand. Most of the time, a company is the customer of another set of companies and the supplier of others. Where you fit into this supply chain is a major driver for growth and future profitability of the business. For life sciences, a new technology enables a new business but the underlying market structure dictates what type of model is possible. This is probably true broadly in other industries as well.
For markets, there are 3 main components - the supplier, distributor, and customer. Suppliers convert the raw materials into products and distributors make sure the customers get them. One side point here is that distributors hold way too much market power in life sciences - the Internet still hasn’t yet revolutionized the field. Onto the main point, horizontal monopolies control one part of this supply chain and vertical monopolies seek to control the whole process in their industry. How concentrated supply and demand for a given product/supply chain is a major driver for a company’s ability to commoditize their complements and hopefully build out a monopoly. This push and pull between these players create new opportunities and destroy incumbents. In life sciences, monopolies are hard to come by - drug development is not a winner takes all market because it’s incredibly difficult, but there are some places in life sciences where building one-of-a-kind businesses is possible.
In order to commoditize a complement, companies should look for markets with sellers that are commoditized or could be - this could be determined by the nature of the underlying technology, how products are distributed, or how fragmented the supply side is. Ideally, a company controls demand and subverts a distributor - if demand becomes more concentrated than supply, the company has a lot more market power. This could be the same for supply but requires a vertical monopoly - think Rockefeller or Carnegie. Finally, many of the customers (demand) in markets that can benefit from a “commoditize your complement” approach are underserved and are looking for a new product to solve their problems. Traditionally, entrepreneurs try to find markets that are very large where customers are probably being over-charged - focusing too much on being a substitute, say outcompeting the competition. A different way, that could be just as effective or maybe more so, is to approach markets where a complement could be commoditized.
Say a company succeeds in commoditizing their complement and owning a large part of a supply chain, companies upstream and downstream will adapt to improve their position overtime (i.e. market consolidation). This leads to the push and pull observed across many industries where companies within a supply chain with the most market power make the most money. To get there, three major approaches can be taken:
A company with a direct relationship with their customers could potentially generate a network effect and have much lower transaction costs. For a PCR device, a company that sells directly to labs would not have to pay a distributor a cut of the sale and would be in a much better informational position to upsell later.
A business becomes magical when costs can stay fixed over the long-term and sales and the number of customers can continue to increase. This only true in software, some places in life sciences right now, and maybe other industries I haven’t thought too deeply about. For life sciences companies from drug makers to synthetic biology companies, the Internet and the ability to market and sell directly-to-consumers (DTC) has yet to be used in any meaningful way. Consumer technology companies are so highly valued right now because they own the customer relationship. Some life science companies have the potential to reimagine existing products. As a result, the largest life sciences companies will serve consumers directly.
Another approach is aggregate supply in a market and use the power to jack up prices wherever you want, find users themselves, or effectively vertically integrate their market. The one burden this approach takes is the continued costs of adding more supply - long-term costs can never be fixed. For life sciences, this approach is probably the most effective - a company dominates an input whether it’s DNA or sequencing machines or a variant of a therapeutic library and uses it to go downstream in some way.
Interesting models are possible when a company takes on aggregating both demand and supply in a market. It’s hard both from a business and legal standpoint but has been done; probably only in consumer software. I can’t think of an example from another industry. Costs are fixed and supply is increasing along with sales allowing a company to focus on product development - maybe only Google has achieved this state and they still face threats, sustaining any business is hard.
By taking these different market approaches, businesses can rapidly change their industries and accrue high amounts of value. Essentially, a company that makes a complement abundant has the opportunity to sell something scarce and create a “desert of profitability around [the] company.” Life sciences companies have a lot of leverage with IP and new ways of distribution to easily implement this type of model. Some of companies like Illumina and Express Scripts are doing it right now to their benefit. Long-term what happens in markets with a dominant player that has commoditized their complement(s), companies elsewhere in the supply chain have too low margins and maybe are too small to invest in their own IP or distribution capabilities to compete in any way. This enables an enduring, large business with little direct competition. More-and-more, companies in life sciences are getting worried that a product they thought was previously neutral might get commodified and disrupt their entire business - think fermentation in synthetic biology or synthesis for drug discovery. Creative companies are emerging that take this approach and will dominate their markets.
This framework is true for pure software products. In general, the idea of commoditizing your complement could work in any industry where software is deeply entrenched. For life sciences, this framework doesn’t work in the same way it works for companies like Google or Facebook, but it could be equally as powerful. This framework really only plays out properly in industries where capital investment can reliably lead to downstream increases in demand/pricing power or where integration within a supply chain is possible. For life sciences, the companies have very high gross margins similar to software companies, software is actually entering life sciences more and more, many biology companies have strong IP moats that allow for large upfront investments to enable higher prices elsewhere, some life sciences companies have high levels of pricing power, and regulatory pathways exist where many advantages can be gained. Moreover, software is hard to rip out and redesign which helps preserve the value of initial capital investments. For life sciences this is true in places like manufacturing standards for an antibody or any biological product. All-in-all life sciences investment can be rewarded through a wide array of options.
Rather than go on and write the equivalent of a senior thesis to make my point - a few examples are sufficient to show the power of commoditizing your complement in life sciences. One important point to make is that there are many more examples in life sciences where this approach does not work. Traditional business models in life sciences will be around for a long time due to market structure, but there is a growing opportunity, due to changing market structure, to build something unique in the field:
Adimab and antibodies
Adimab invested large amounts of capital (at least $40M) to build out its yeast platform for antibody humanization. They didn’t do this because of the cool science or platform - by bringing of cost of antibody humanization to as low as possible, enabled Adimab to go downstream for antibody licensing (pre-IND) and increase the number of deals they could execute - https://www.adimab.com/partnering This is true for every platform company in life sciences. The purpose of investing in platforms is to bring the cost of say discovery down to lead to more drugs down the line. Platform companies (i.e. AI for drugs) often focus on increases in predictability that have not been proven to happen in biology - more shots on goal right now is the better value proposition for these companies.
Illumina and sequencing
Illumina executed a razor-and-blade business model for sequencing. Relying on sequencing-by-synthesis and its model, Illumina ultimately won the sequencing wars of the 2010s - https://www.genomeweb.com/blog/war-sequencers
https://www.forbes.com/sites/matthewherper/2011/01/11/illumina-strikes-back-in-gene-machine-wars/#4e6f7bd945cb The company drops prices of sequencing every few years, just enough to keep the competition away and increase demand for its consumables. Illumina right now really is similar to Intel in the 1990s.
Benchling and a design tool
Benchling has given a biological design tool for free to build out a sizable life sciences user base to ultimately increase demand for the automation tools the company has been building - https://www.benchling.com/2018/10/23/what-is-a-lims/
Novartis and academic research
Novartis has invested sizable amounts of capital in research at UC Berkeley to make new discoveries that could ultimately lead to new drugs for the undruggable genome - https://www.novartis.com/news/media-releases/novartis-and-uc-berkeley-collaborate-tackle-undruggable-disease-targets. The commitment created the Novartis-Berkeley Center for Proteomics and Chemistry Technologies. Many companies in biopharma have done similar work with some controversy within academic communities. Even though the research done at the center could lead to more drugs for others (i.e. Frontier Medicines), Novartis will benefit overall from more research focused on one of the most important problems in drug development. This approach is similar to how Google and Microsoft both invest in Linux.
Twist Bioscience and synthesis
Twist is more of a drug company than a synthesis company - the public market is valuing it this way and the company’s decisions show that this is the case. Twist is in a tough spot right now where the synthesis market is relatively small (around $1B if you’re lucky). As a result, Twist is decreasing the cost of synthesis, slowly similar to Illumina, to increase demand for its antibody libraries - https://www.twistbioscience.com/products/libraries and https://www.twistbioscience.com/sites/default/files/resources/2019-06/Flyer_BioPharma_TAO_AntibodyOptimization_NT_L3b_7Jun19_Rev1.1_0.pdf
Express Scripts and drug prices
Express is one of the largest players in pricing drugs - https://prospect.org/health/hidden-monopolies-raise-drug-prices/ Express along with the five other top pharmacy benefit managers (PBM) own over 95% of the market. With such a large market share, Express (~20%) along with the other PBMs make distribution of drugs from the drug companies to patients seamless and low cost in order to gain a stranglehold on its ability to determine which drugs get reimbursed and by how much - https://www.drugchannels.net/2019/05/cvs-express-scripts-and-evolution-of.html Bundled healthcare payments, the idea of giving a set amount of money to take care of a patient or a population, threatens this model. Express Scripts is a case study to explore why reducing the prices of a drug’s complement works but the opposite has not yet been shown to be successful. Reducing the price of medicines does what? Increase demand for doctors? Clinics? Not clear to me. It seems the “commoditize your complement” model works to essentially give away low-margin products to get pricing power for higher-margin ones.
Parker Institute for Cancer Immunotherapy and clinical trials
The Parker Institute (PICI) has been at the forefront of revolutionizing clinical trial design particularly for cell therapies - https://www.parkerici.org/the-latest/smarter-bolder-cancer-immunotherapy-clinical-trials/; pushing forward concepts like master protocols and basket trials. By making a large investment in helping the broad medical community - making clinical trials more predictable, better designed, and more accessible - the Parker Institute will benefit mainly by investing in companies that use the biotech railroad for cell therapies that it has built out - https://www.parkerici.org/research/model/
Deerfield and translational research
Deerfield has put money into the Broad Institute - https://www.broadinstitute.org/news/broad-institute-and-deerfield-management-launch-innovative-partnership-tackle-serious-unmet and Columbia - https://news.columbia.edu/news/columbia-university-and-deerfield-management-launch-hudson-heights-innovations as well as other univsersities to support translational research. But they didn’t do this out of the goodwill of their hearts. Deerfield is investing in helping discoveries get to the point of enabling new companies without exclusivity, they probably get first looks, because it helps their downstream business of investing in life sciences companies. Deerfield is hoping to increase the number of companies they can invest in.
These examples show the positive impact for patients and customers that bringing down the prices of a complement have. The opportunity is to bring these ideas to the process of making medicines and design new models to bring biological products directly to consumers and enterprises. Business model creativity could make companies in infectious disease particularly antibiotics and NTDs, devices, and molecular diagnostics more feasible and increase access to much needed technologies. Really, focusing not only on substitutes (i.e. competition) but complements as well can build business models that can impact their market - expand it, redistribute it, and control it. This could lead to more monopolies (in the best way possible) in life sciences emerging. For individuals building their life sciences companies, the question should be what are your complements?
Also, with regards to COVID-19 and the downstream effects: keep your loved ones safe and carry on. I’m grateful we live in an era where we have the technologies and healthcare system to monitor this virus and one day treat and cure it. The Show Must Go On.