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(originally published by Booz & Company)


Hotbeds of Innovation

U.S. multinationals are looking to small companies and startups for the next big ideas.

As companies in Asia and Latin America transform themselves from low-cost manufacturers to competitive innovators, many U.S. multinational corporations are confronting a strategic dilemma: Although under pressure to stay ahead of their often-flush global rivals, these multinationals are being forced to revisit their R&D budgets — a consequence of weak sales at home, where consumers are nervous about spending.

Some companies have responded by offshoring design and engineering to drive down costs. IBM, a well-known example, has invested significantly in its presence in China and India. Others have adopted open source policies that encourage collaboration, such as Procter & Gamble Company’s “Connect + Develop” platform, which lets P&G and external product and process designers share technologies and know-how. But another option is growing more popular. Called “ecosystem investing” by some innovation executives, it refers to the increasingly complex network of suppliers and innovators supporting large companies.

In this model, well-established U.S. companies are creating strategic partnerships with startups and small companies whose technologies and skills can help the large companies expand their own capabilities. Longtime ecosystem investors such as Johnson & Johnson (J&J) and Intel are driving existing ventures toward advanced breakthroughs, and companies such as General Electric, General Motors, and Google have adopted the approach in earnest in recent years. The goal of the incumbents is to systematically target emerging technologies and “harvest” ideas without having to take on the risk of acquiring the smaller companies. Sometimes the large company takes an equity stake, and its top executives may sit on the small company’s board or mentor its top management. Alternatively, it may seek to license the small company’s technology or buy its products and distribute them to global markets. In all these arrangements, the strategy is to use external partnering to tap into startup sectors, for example, genomics and biotechnology, advanced robotics, lithium ion batteries, semiconductor manufacturing, and nanotechnology.

As many as 12 drugs in J&J’s stable of products resulted from ecosystem investments, says Garry Neil, vice president in charge of the company’s science and technology office. To find potential partners, Neil’s office scours biotechnology clusters in cities such as Boston, San Francisco, and San Diego. “The secret sauce for the United States is the research universities and institutes, which are unparalleled in their ability to innovate, and to attract the best and the brightest from around the world,” says Neil. The company is not trying to push the frontiers of knowledge as much as it is seeking to find technologies that can be commercialized. Adds Neil, “We focus less on winning Nobel Prizes and more on trying to come up with something that people are willing to pay for.”

Neil has money earmarked in his budget to invest directly in startups, and if necessary he can seek additional funding from the Johnson & Johnson Development Corporation, an internal venture capital fund. “The idea is to make the wall between [J&J’s] R&D unit and small, academic companies porous,” he says. In 2006, for example, Ortho-McNeil Inc., a J&J division, invested the modest sum of US$40 million in Metabolex Inc., a privately held biopharmaceutical company based in Hayward, Calif., so the two companies could collaborate on the development of compounds used to treat type 2 diabetes. The arrangement paid off for both firms. Metabolex enjoyed a vital infusion of capital at a time when it was circling the “valley of death” — what venture capitalists sometimes call the period when many small companies are spending heavily on up-front research but have not yet begun to reap the rewards. And J&J obtained access to a technology that could arguably be developed faster and more cost-effectively at a small company than through its own R&D pipeline. In June 2010, Ortho-McNeil received an exclusive worldwide license to commercialize several Metabolex drugs, including the diabetes compound, for about $330 million. That’s far less than the $1 billion a pharmaceutical company typically spends to develop drugs internally, and far more than Metabolex could have expected to bring in on its own.

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