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Buying A Company Is Not R&D Spending

I wanted to address an issue that came up in a comment to the last post. Here we go:

When you start a company like VRX, the sales can not support 15% of sales R&D. So they buy other drugs which, with all due respect, is equivalent to spending on R&D, IMO. I miss your point that it is not (i would love it if you can explain it again).

Gladly. I see where this commenter is coming from, in one respect. Let’s say that Company X has discovered and developed a drug. When a company like Valeant goes out and spends (say) 500 million dollars buying Company X, they are indeed spending money on the R&D efforts of Company X. But that’s not the same as spending 500 million on R&D yourself. Company X spent their money on chemists, biologists, formulations scientists, toxicologists and more, on lab supplies, NMR time, stability testing, LC/MS maintenance, rodent chow, and a list that goes on down the page. The people who do all this work are specialists who have put many years of their lives into learning their fields, and are paid accordingly. This is all what I mean when I talk about R&D spending.

Valeant waited until Company X had already spent all this money, of course. They are not so foolish as to spend their own cash on such pursuits. I mean, look at Company Y down the way. They did something very similar to what Company X did, but their drug didn’t work in the clinic, so Company Y is no longer with us, and all of its people are looking for new jobs and wondering how they’re going to pay their mortgages. Valeant is free to then buy Company X, since their drug survived, but in doing so they spend no direct money on R&D per se. In fact, when they buy Company X, they are going to sell all the research equipment as surplus, shut down the building and turn off the lights, and fire every single person who was working in the labs. They have actually destroyed R&D capacity – that’s part of their business. They take great pains to shut down research activity as quickly as possible when they buy a company, because all that stuff costs money, and it’s dedicated to something that Valeant has no interest in or need for: trying to find the next new drug. That’s a job for other people at other companies.

The money that Valeant spent to buy Company X does not cause any further R&D to take place. It goes into the pockets of the shareholders of Company X, who are now shareholders of Valeant. Mutual funds, pension funds, money managers of all sorts: these folks held the great majority of Company X’s shares, and they have been enriched by the transaction, and presumably have no reason to complain (or they wouldn’t have voted their shares for the deal). These folks are free to invest in another R&D company, of course, but they don’t have to. They can do what they like. Maybe the housing sector is hot right now – the money will all flow over there instead. Some of the shareholders were probably officers of Company X itself, who (though enriched on a smaller scale) are also probably now out of a job. Some of them might go back and try to found new companies, but the money they got from this affair alone won’t do that, and some of them are just going to retire or try to find work at another company somehow.

If I buy an existing building, I am not spending money on architecture. If I buy a hundred-year-old painting, I am not spending money on brushes. And if I buy a drug that has already made it to the market, I am not spending money on R&D. I hope this has clarified my point.

42 comments on “Buying A Company Is Not R&D Spending”

  1. Andy II says:

    Derek, I could not agree more on your point. We need to keep in mind that what stage that asset was acquired. When someone buys asset at pre-IND or at phase 1 from Company X, someone has to spend a lot of money to complete the development, including additional CMC, preclin, and clinical, where most of development money gets consumed. Your argument is when someone buys Company X that has a commercial product, which would not require “further” resources, a status quo. However, there are lots of work need to be done to maintain the market exclusivity, label expansion thru a series of clinical studies (like many are doing now with cancer immunotherapy), safety monitoring (post approal commitment), pediatric studies, which all fit in “D” of R&D. Having said that, but I do not agree to justify the logic of buying someone else’s asset is spending their own money for R&D.

  2. johnnyboy says:

    Agreed. Put in simple business terms, what Valeant is doing (acquire a company for its drugs and then liquidate its R&D) is buying an asset. Investing in R&D is essentially an expense, not an asset. You are hoping this expense will brings future assets down the road, but it may or may not. Saying that buying an asset is the same as an R&D expense is nothing but the most disingenuously faulty reasoning.

  3. Tom Womack says:

    What is the incentive for Valeant to spend $500 million on a drug plus a large number of researchers which it has to make expensively redundant, rather than giving the small-pharma $200 million in exchange for total rights to the drug, money which the researchers can then spend on more NMR time and more mouse food while aiming at the next drug target?

    Do the shareholders in the small-pharma believe that success at one target is strictly uncorrelated with success at another, in which case of course they should leave the poker table as soon as they’ve won the pot? I can see the blockbuster-drug model in which a big pharma reckons it could make enough billions from a really successful drug that it should not possibly risk letting someone else have a chance at those billions; but if you’re a small-pharma then you’ve given up on the chance of the billions already and your purpose in life is to sell well-tested drug ideas for their estimated net present value.

  4. Isidore says:

    While I agree in principle with the above argument and in connection to companies like Valeant, I think that there are a number of gray situations where acquisition of a company’s assets ends up supporting R&D. Andy II made such a point with regard to development and there are instances (in one of which I was personally involved, as a scientist helping with due diligence) when a company A buys some promising technology or research from strapped-for-cash Company Z, which then Company A continues pursuing in its own organization, spending money and keeping its own research scientists gainfully employed. But Company A neither retains any of Company Z’s employees nor does it keep any of the latter’s labs or facilities open.

  5. Noname says:

    With all due respect, folks, if the selling company accepts $X as a fair price for their past efforts to develop a drug, then that is perfectly legitimate and acceptable. I sure hope that neither you nor some government now wants to ban this kind of business model. It happens every day in the tech world, or anywhere else. What should be vilified and solved is the unjustified hiking of prices. However, it will be difficult to do in this country through anything other than public shaming.

  6. John Tucker says:

    Derek, the problem with your argument is that none of those chemists and other scientists would have been hired in the first place if the VCs that funded the start-up did not know that, if successful, there would be a market for the product they were developing.

    Diffferent investors have different risk tolerance and play different roles in the process.

  7. Richard W says:

    Thank you for taking the time to respond to my request. I understand your point and I will agree that what VRX does is not R&D spending. But would you agree that what VRX has done to its acquisitions is very akin to what the major pharmaceutical companies have done when they took over their similar size brethren. When Merck took over Schering Plough for $41 billion it was to gain control of Zetia (ezetimibe) a drug it already had a joint-venture with its own cholesterol reducing agent. In addition, a big justification for the merger was the synergies (read cost cutting) to be had. Given the overlap in R&D, SGP department must have taken its fair share of the axe. Do you advocate that R&D be the sacred cow? When I look at sales per employee and how many employees big pharma employs vs. similar size biotech companies, there are lots of inefficiencies that the “free market” will naturally seize upon (I use the free market loosely for the drug industry as it is not free given the ability to charge monopoly pricing and the barriers it imposes to maintain this even after patents expire: use of dubious process patents and paying off generic companies not to enter the market).

    Company Mkt Cap Employees Sales/Emp
    ($B) ($Thous)

    Pfizer 204.1 78,300 615.6
    BMY 100.9 25,000 655.2
    Gilead 148.0 7,000 4,170.0
    Celgene 93.3 6,012 1,402.2
    Valeant 57.9 16,800 551.2

    There has to be a lot of scientists in those huge employee numbers of Pfizer and Bristol-Myers-Squibb.

    1. Value says:

      Do you realize that you just showed us numbers that show all the other pharma companies generating more sales per employee than Valeant even though they all carry massive R&D departments as opposed to VRX?

      For what it’s worth I totally agree with Derek’s argument, but regardless of it, as a finance guy myself, I can tell you that what you just showed us is what will kill VRX investors. They work around thinking that they hold this incredible company that i much more efficient and much more profitable than its peers because, just pic a talking point:

      They don’t spend on R&D – true
      They pay little to no taxes – true
      They use these consultant buzzwords like zero based budgeting to be lean – yah.. cool story.. but I’ll let everyone figure out whether it’s true.
      Add anything else you want to add… synergies blablabla

      But when it’s all said and done, all the other supposedly dumb pharma companies that waste money on R&D, are massively more profitable than VRX who relies on adjusted numbers and murky accounting to tell its story.

      And after all that you look at the $30B in net debt staring you in the face and somehow people hope that this will end well. Shame.

      So look at your numbers and then tell us why taking care of inneficiencies somehow leads to VRX having less sales per employee than their peers that are so dumb and so wasteful.

      Thx.

      PS: Good job Derek

    2. Philip says:

      All these numbers tell me is that Gilead employees deserve raises, or at least cake.

      1. Anonymous says:

        I work at Gilead, and I can tell you that they spend far too much money on cake as it is. We would much rather have a raise.

  8. Isidore says:

    I think this is a philosophical argument rather than one about ethics, let alone legality (although there may be tax implications for a company, I have no expertise there). Can the money spent by Company A on buying the assets of bankrupt Company X, with such assets comprising potentially useful products, such as drugs, which however are not yet being sold and in fact may never generate any sales income because they are still at some pre-market development stage, be counted as R&D spending? I would argue that such spending is, in fact, R&D spending. How late does a drug have to be in the development process so the cost of its acquisition cannot be considered R&D spending?

  9. Richard W says:

    Sorry about the garbled table. Case in point, Bristol-Myers-Squibb and Celgene have similar market caps, $100.9B and $93.3B, respectively. BMY employs 25,000 workers and CELG only 7,000. BMY sales per employee is $655.2K and CELG is $1,402.2.

  10. biotechtoreador says:

    “Company X spent their money on chemists, biologists, formulations scientists, toxicologists and more, on lab supplies, NMR time, stability testing, LC/MS maintenance, rodent chow, and a list that goes on down the page”

    And then Company Y came along and bought that: seems to me Company Y spent $X on R&D. I just don’t see the difference between allocating $ directly and doing so secondarily.

    “The money that Valeant spent to buy Company X does not cause any further R&D to take place.” I disagree. The business model of many Company Xs is to discover/develop drugs with the goal of being acquired by another company prior to commercialization. By acting as acquisitor VRX is here spurring on R&D by these companies seeking to be acquired. Supply meets demand, and everyone gets paid.

  11. Eric says:

    @biotechtoreador
    Sadly, I tend to agree with you. Valeant is paying for R&D secondarily. Although as Derek points out, it’s not sustainable for the entire industry. Some companies must do R&D or there is nothing for the Valeants of the industry to buy. Over the last few years I’ve begun to wonder if the whole industry isn’t headed in that direction: a handful of big pharma companies that perform late stage clinical trials, market, and sell drugs with a lot of small biotechs that do discovery research until they get bought up.

    What’s always bothered me is your last comment “Supply meets demand, and everyone gets paid.” Unfortunately that’s not the way it works. Every shareholder and officer gets paid (some quite well!) while the R&D staff generally get a small severance and unemployment while they hustle to find another job. It’s never seemed as if the people that actually discover the drug get fairly compensated in a buyout. Of course that’s true across most industries, not just biotech.

  12. Derek Lowe says:

    There are several lines of argument being mixed together here. It is true that many startups are operating under a model of eventually being bought out – I’ll do a follow-up post on that, because it’s a point that should be emphasized. These folks are (often) one-drug companies, or one-project companies. They spend their time and money curating that asset that some larger company might want, and shopping it around as it becomes attractive. The people doing the research at these places know where they stand, and the points being made here in the comments about this being an incentive for research are valid.

    This isn’t the case with something like the Merck/Schering-Plough merger, or the Pfizer takeovers of Warner-Lambert, Pharmacia/Upjohn and all the others. Few to none of the R&D people in these cases wanted the deals to go through, because they knew what was likely to happen (which is indeed what did happen). And no one, frankly, wants to be bought by a company like Valeant, whose near-contempt for the entire idea of internal drug research has been plain for years. The people who want these deals to go through are upper management and shareholders, along (naturally) with the investment banks getting a piece of the action. Cephalon was not a small startup looking to be acquired when Valeant bought them, just to pick one example.

  13. Richard W says:

    In the big mergers, would argue most of the senior management do not want to be bought out. If I had a well paying executive job making $300K, getting options on a stock that was growing nicely, executive perks, gold health insurance policies, why would I want to get bought out even if I got a golden parachute? Now I have to look for another job? Job security + money + perks > golden parachute. But the free market does not give you guarantees. I understand you used to work in research, but did you have any sympathy when all the US iron workers got run over by the global economy in the 70’s and 80’s? Darwinian economics sucks, but its the best system we have.

  14. imarx says:

    Another way to look at it is that these companies aren’t really paying for R&D, rather they are paying the premium for *successful* R&D, i.e. the cost of not having to deal with failed R&D. They are two different things.

  15. jeffbobw says:

    The problem with many of these arguments is that purchasing a company is being conflated with R&D funding. R&D is an expense period. It does however produce IP which is an asset. When a company is purchased those IP assets are transferred to the new owner, but no new IP is created, so you’ve simply paid for assets that already exist and transferring the cost of creating those assets from the original owners to the new owners.

  16. dave says:

    Said simply the acquirer is buying the future and the target made the investment in the past

  17. Andy II says:

    @jeffbobw, it is a big task to create a new IP as a part of life cycle management of the product, which is already or soon to be on the market. A different formulation (extended release or pH-controlled release) from the current product (needs to demonstrate tangible benefit over the current RLD, in reality, not much unfortunately). A “different strength” for “optimum” safety/efficacy for a “different indication” (so that no one can use the current product per se to meet the “right dosage form”). A different crystalline form for better stability or safety. Or, a different manufacturing process or monopoly of API. One of those strategies was used by Martin Shkreli though all are very common.

  18. Jeff says:

    Do the people selling the drugs to these companies not deserve some of the “blame” as well?

    Particularly those who sold to someone like Shkreli’s company, where we know what his game is based on his prior company.

    Secondly, what would you say about a company that spent 500 million on R and D, got a drug out of it, then shut down all of that R and D, and subsequently charged Valeant type prices?

    I know it’s not exactly the same thing as what Valeant did, but couldn’t you argue there are some similarities? I guess the primary difference being that under my hypothetical, it’s guaranteed that the 500 million leads to payout of this drug, whereas in the real world, this is of course far from guaranteed so they are by definition taking a gamble.

  19. jeffbobw says:

    @Andy II. I agree with you. After 25 years in pharma, I’m very aware of all the costs associated with bringing and keeping products on the market. And if that work is done after the acquisition of the company, then it’s a legitimate R&D expense. However the Derek’s premise, which I support, was that no part of the purchase price for the acquired company should be attributed as R&D. That’s changing history. When company A buys company B the actual R&D spend for the previous year (or 10) doesn’t magically change from R&D spend (A + B) to R&D spend (A + B +f(purchase price)).

  20. entropyGain says:

    Actually, from an accounting perspective, acquisitions are often rolled into the R&D budget. Go read some of the financial statements of the major pharma if you don’t believe me. Sadly, when they report spending XX% of revenue on R&D, often that includes acquisitions, licensing deals etc and post-approval marketing studies designed to do little more than build loyalty within the investigator community. It then gets rolled into the “Cost of Developing a Drug”.

    Lies, damn lies….. and accounting.

  21. Maybe I’m missing something, but I don’t even know why there’s an argument here. The Valeants of the world are only interested in buying Company X (which necessarily includes an R&D department), because Company X’s R&D was successful in producing revenue-generating Product Y. Valeant might be buying the nuts and bolts of Company X’s R&D (literally buying R&D) when it buys Company X, but what Valeant really cares about is the fruit of Company X’s R&D–ie, Product Y. You’re only investing in R&D if you take the risk of R&D. Valeant’s not interested in that risk: that’s for suckers, fools, etc. Valeant wants the winning lottery ticket, not the headache of finding the winning lottery ticket.

    My original question from the previous post (which is more of a rhetorical question) was Why does Valeant even bother to allot 3% to R&D?

  22. Ken says:

    Interesting. Until I read these comments, I had not realized that I had invested $8.10 in drug R&D this evening. Oh, I thought I was buying dinner at a fast-food restaurant, but I happen to know that the chain has an employee pension plan, and the pension plan invests in mutual funds, and the mutual funds have holdings in drug companies. So my $8.10 was spent on drug R&D – it was just five steps removed from actual spending on agar and rat chow, instead of the two steps in Valeant’s case.

    1. any says:

      Fast food workers with a pension? You people are clueless.

    2. Ken says:

      @any: Oh, yes, that workers may not have a pension completely destroys the link between my $8.10 and the R&D investment. Fortunately I also paid my phone bill online last night, and those workers do have a pension, so I’ve definitely made a sound R&D investment. Five steps removed.

  23. M says:

    If you buy a truck for your company you don’t go telling people you were spending money on factories. A truck is a product made by a factory, not actually a factory.

    A new drug is the product of research, but it should be obvious it’s not research.

    Obviously spending on products like drugs and trucks gives people an incentive to do research and build factories, as has been pointed out. But making money as a middleman without doing research also gives people an incentive to be middlemen who don’t do research.

    Normally the argument is that middlemen help get goods to people who need them so it’s net positive anyway, and I believe that more often than not. But it’s not necessarily the case, and when there’s limited competition in an area like drugs, it’s completely possible to reduce the overall welfare and put something in your pocket at the same time.

  24. Richard W says:

    This is in response to Value, 5:52 PM. My table was primarily to point out that large cap pharma is less productive when compared to a similarly sized biotech company. Comparing BMY to Celgene which are very similar in market cap, Celgene is more productive. Your usage of the word profitable is incorrect if you are using my table, since these are not measures of profitability. For profitability, look at ROIC which incorporates debt (read: VRX $30billion) If you look at ROIC, VRX is 8.4%, while BMY and PFE are 6.4% and 8.9%, respectively. While this may look favorable for PFE, ROIC is based on historical accounting, so PFE denominator is loaded with old assets recorded at historical prices. If PFE assets as well as VRX assets are mark to market, VRX ROIC would be much higher as it is a much younger company. So I still stand by my statement that big cap pharma R&D is not very productive. Given that biotech is more productive also validates my point that R&D spending from big pharma tends to be unproductive – its results can not move the needle for these behemoths. But the same will happen to big biotech, it’s really the law of big numbers. VRX at its stage of life is better concentrating on buying assets than trying to fund expensive R&D with their current revenues. Unless VRX is cooking its books like Enron, even with this correction, investors made out better with VRX than any of the large cap pharma.

  25. Tripod says:

    There are at least three flavors of worker that can be in a pharma company. Even Valeant.

    1. The people who build
    2. The people who design
    3. The people who check value

    To view this through the rose colored glasses of a medicinal chemist, one might visualize the first type as the scientist working in a fume hood with flasks and searching scifinder for the perfect reaction to synthesize drug Z. The second type is the scientist who reads the literature on structure-based drug design and says, “let’s spend our time probing SAR around drug type Z.” The third person is busy reading patents and and publications and is asking all along, “should we pay for a program surrounding drug Z? Should we fast-follow? Should we devote to a first-in-class Z? Or would we be better off with owning drug programs for Compound W? And since drug Z is nearing the market, is it garbage or does it really work?”

    The thing is these 3 might be just one guy. Or maybe 3 different guys. Or maybe 2000. They’re like the fire triangle. Take away a little of one and the fire of any pharma company burns less hot. Maybe is even snuffed out. Valiant happens to place its emphasis on type 3. We can ask “So how is that going for them compared to other companies?”

  26. Richard W says:

    And just to round it out, the ROIC of Celgene and Gilead are 16.3% and 44.8%, respectively. Gilead huge ROIC can be attributed to its $11 billion acquisition of Pharmasett and it nuc, now known as Sofosbuvir (after Gilead realized its own R&D produced nuc wasn’t up to the task)

  27. MonkeyBusinessAxepert says:

    Richard’s sole emphasis on ROIC tells pharma and biotech should not be run by MBAs but scientists.

  28. Kelvin says:

    Buying or licensing assets at fair market value is not a viable business model to create value.

  29. Hap says:

    1) What makes T$&@$- Pharm. more execrable than Valeant is their use of “closed distribution” to enforce their price increases. If someone doesn’t want to buy from Valeant, they don’t have to, in most cases, but that’s not true with T&@$&@.

    2) If most of pharma has this as their model, then what is their justification? Much of the reason for HCV med expense is that Gilead bought Pharmasset and had to make their money back before competing drugs reached the market. This doesn’t sound a whole lot better than T$&@/-, except for the “closed distribution” gambit.

    At this point, the “We need money for R+D and that’s why we charge so much” justification is getting less and less valid. “Because it’s worth it” will be hard to swallow (I don’t need a BMW, but I could very well need a drug that costs like one); it won’t help with marginal anticancer drugs, but at least it has the virtue of being true.

  30. Mat says:

    Some food for thought: Would this class of product change be more stomachable if they were -just- getting the rights to that product instead of the whole business?

    Hell, it would seem to me it’d make more sense to at least attempt to buy the product rights instead, saves you the hassle of dealing with all the other stuff.

  31. Daniel T says:

    Hap – love the new name T&@$&@ Pharma!

    I wonder what would happen if some company decided to call T&@$&@ bluff and parallel import Daraprim and sell it at $15. Would the FDA just sit on their hands (or drag their feet) on enforcement while T&@$&@ imploded?

  32. Research chump says:

    That’s why working in research is a waste of time. Work hard and come up with something so you’ll get fired.
    unless you’re part of the “in crowd” you will most likely just have your ideas stolen and get very little reward while the noisemakers laugh all the way to the bank.

  33. matt says:

    I think what Richard W and biotechtoreader are missing is how Valeant is really making money. In a reasonably priced market, what return can you expect from a no-risk investment? That’s what Valeant is doing by buying drugs post-clinical-trial and approval. Unless companies are just being stupid about what their product is worth, this is NOT where Valeant is making money.

    Instead, Valeant is the same excrement stuffed in a shiny new sack. It’s a farmer selling off the seed corn, and planting the most nutrient-sucking money crops he can as often as he can, because he’s not planning on being around long. He’s working the Ponzi scheme instead, buy it up, use it up, spit it out, and meanwhile baffle as many as possible with your bull as possible. It’s Maxxam taking control of Pacific Lumber, and starting to clear-cut hillsides and cut/sell off all the old growth stands, and generally looking for every way to screw the customer and the community and take a crap in the planetary “bed” we all share, to make a little more money and because they can.

    And, like the Maxxam / Pacific Lumber case, when pissed off customers and fellow community members and all the others harmed and outraged by their selfishly inflicted damage band together and get the government to start setting rules and boundaries, they will flop and scream about outrageous government interference and burdensome regulations. Oh, those regulations are harming their poor employees, the ones they haven’t yet laid off (previously layoffs will now be retroactively blamed on the government).

    The most despicable thing, perhaps, is that with this business model, Ackman will still talk about sustainability and corporate accountability and shorting some company because they are scamming people (like he is). Yes, it’s clear why he and Carl Icahn get along well these days.

  34. Ann O'Nymous says:

    I think imarx said it perfectly: what is being purchased here (at one remove) is successful R&D, not R&D per se. Where I think Valeant and their ilk go wrong is that they buy the company and not simply exclusive rights to the drug. Wouldn’t a better $$ model be for them to license exclusive rights to the product of R&D shops A, B and C, thus leaving A B and C to continue as independent entities (and now flush with cash to buy really nice rodent chow…or snacks in the breakroom, which might be the same thing, now that I think about it).

    That way no one loses their job, Valeant get the product without the pesky business of laying off R&D people, and researchers get a way to do what they do with a cash payout as the reward for discovering/inventing the next Lipitor.

    Thoughts?

  35. Dr Harpic says:

    Hap/Daniel T – Let’s flush the chain and from now on refer to the company as Tur*ing, the first 4 letters being the pseudonym of the company’s founder…

  36. Richard W says:

    @Matt. The drug industry is not an efficient market as you alluded to which is why VRX can make a profit in a “no-risk” investment. The financial numbers say that (even if you choose to ignore the stock price appreciation). Not all companies are run that well and being successful in the drug business can be serendipitious, ie LLY lastest R&D miss. Lose the emotion and the judgementality. This industry spends almost as much on marketing as it do on R&D. It convinces docs (by sending them to “academic” lectures in Hawaii) to prescribe expensive new Rx that at best are marginally better than older and much less expensive drugs.

  37. Richard W says:

    http://www.nature.com/nrd/journal/v11/n3/fig_tab/nrd3681_F1.html

    great chart about R&D productivity and the FDA regulation.

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