Pushing Pills?
Shareholder Influence on Radical Innovation: A Case Study of Large
Organizations in The Pharmaceutical Industry
Master Thesis
M.Sc. Business Administration – Strategic Innovation Management Faculty of Economics and Business
University of Groningen June 24, 2018
Student: Camille M.L. Zaaijer S2343398
Thesis Supervisor: Prof. Dr. D.L.M. Faems Assessor: MSc. N. Balogh
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ABSTRACT
Based on a single case study in the pharmaceutical industry this research provides a process model visualizing shareholders’ influence on radical innovation in large firms. This research builds on the existing division of perspectives on shareholder influence on large firms’ innovation, adding a specific radical innovation focus. The findings show an influence process, starting with shareholders’
willingness to invest, leading to the emergence of the dominant shareholder model within large firms, changing the R&D context before ultimately impacting radical innovation. Radical innovation within large pharmaceutical firms have become; (1) narrow in scope, (2) high priced, (3) non-implemented or ineffective, (4) external placed, and (5) commercial in nature. The findings within this research are similar with existing research and in line with the existing ‘myopic’ vision on shareholder influence. The research contributes to the existing literature by providing a complete overview of the influence process involving different levels and parties. The model provides managers with insights in the influence process and a tool to determine which parties to involve or appeal during the radical innovation process in order to stimulate radical innovation. Future research should focus on different shareholder types and their individual influence on radical innovation.
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INTRODUCTION
In 2007 Organon, one of the Netherlands’ most successful and leading pharmaceutical firms, was sold by parent company, AkzoNobel. Until then, Organon was a growing and successful pharmaceutical firm known for the development and production of the best-sold birth control pill. After being sold under pressure of AkzoNobel’s shareholders and due to the thirst for short-term profits, Organon quickly declined under new regime of, first, parent company Shering-Plough, which was then bought by Merck & Co. In 2010, Organon got dismantled (Burgers, J. and Heilbron, J., 2018).
According to Burgers & Heilbron (2018) Organon’s downfall can be blamed on the short-term interests of today’s shareholders. A vision not only controlling shareholders and the financial market, but entire industries. This short-term focus has proven to be destructive, especially in complex and highly technological firms (Burgers and Heilbron, 2018). The downfall of Organon meant the
disappearance of 80 years of high quality and specialized knowledge, expertise and experience. Along with potential future innovations which have been recognized as critical for firms’ survival (Artz, et. al., 2010; Assink, 2006;Burgers and Heilbron, 2018; McDermott and O'Connor, 2002).
As previously mentioned the importance of a firm’s ability to generate a continuous stream of innovations is critical for survival, especially radical innovations (Artz, et. al., 2010; Assink, 2006; McDermott and O'Connor, 2002). Although, consensus on a clear definition of radical innovation has not been developed, the difference in management of radical innovation versus incremental innovation has been well documented (Cardinal, 2001; Chang et. al., 2012; Dewar and Dutton, 1986;Hill and Rothaermel, 2003; Koberg et. al., 2003; McDermott and O'Connor, 2002; Sorescu et. al., 2003). Management and development of radical innovations, mostly based on radical technological change, often challenges large incumbent firms, who often fall behind start-ups (Benner, 2010; Chang et. al., 2012; Henderson and Clark, 1990; Hill and Rothaermel, 2003). Gaining support for radical innovation projects is often difficult, where internal cultures and pressures from both internal and external parties often push efforts towards more low risk, immediate reward, incremental projects (Benner, 2010; Benner and Tushman, 2003; McDermott and O'Connor, 2002).
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Shareholders’ power has become bigger over the past decades. Where until the 1970s management of organizations were able to manoeuvre in freedom, nowadays management has to focus on
shareholders’ interests and defining strategies that create shareholder value and even maximizes this (Aglietta and Breton, 2001; Fligstein, 1993; Lazonick and O’sullivan, 2000). ). Although, at first the move towards rehabilitating shareholders’ interests was to prevent management from acting solely out of own interest, today it seems the tables have turned and management should solely act in interest of their shareholders (Aglietta, 2000; Lazonick and O’sullivan, 2000). These shareholders, which in most cases are institutional investors, have in their turn increased their influence on organizations’
management substantially (Aglietta, 2000; Stockhammer, 2005).
Opinions within existing literature on this shift in corporate governance and shareholders’ influence on management of organizations are mixed. Where some argue that focus on shareholder value increases efficiency and corporate transparency (Choi et. al., 2014; Stockhammer, 2005), others argue that shareholder focus imposes termism; the sacrifice of long-term profit to the achievement of short-term financial targets, at the expense of longer-short-term R&D. (Lacetera, 2001; Mc Namara and Baden-Fuller, 2007;Tylecote and Ramirez, 2006). According to Tylecote and Ramirez (2006) shareholders over-emphasize short-term earnings at the expense of longer-term R&D. If shareholders hold a certain bias, as professed by March (1991), against longer-term investments for research in, or exploration of, new technologies in favour of exploitation of current firm knowledge this could have important policy implications for the firm's R&D investments and innovation portfolio.
As the example of Organon implied, pressure of shareholders towards low risk, immediate reward and incremental projects could lead to the loss of significant knowledge, expertise, experience and
potential innovations. Existing literature researched the impact of incremental versus radical
innovation announcements of firms on potential shareholder reactions in the stock market (Mc Namara and Baden-Fuller, 2007). However, research defining shareholders’ influence on radical innovation within complex and high technological organizations, as pharmaceutical firms, is lacking.
This study will focus on the influence of shareholders within large pharmaceutical firms on radical innovation. During the course of this research the following research question will be answered: “How do shareholders in large pharmaceutical firms influence radical innovation?”
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THEORETICAL BACKGROUND
Definition of Radical Innovation
Innovation is crucial for firms that operate and compete in dynamic environments where change is inescapable, unpredictable and continuous (Koberg et. al., 2003). By reason of increased levels of competition, turbulence and decreased product-life cycles in today's markets, existing research suggests that specifically, the development of new products or services based on radical innovations are critical for firms' competitive position and profitability (Artz, et. al., 2010; Assink, 2006; McDermott and O'Connor, 2002). In recent years a substantial part of innovation research has concentrated on defining different types of innovation, mainly incremental and radical innovation (Bers et. al., 2009; Cardinal, 2001; Chang et. al., 2012; Dewar and Dutton, 1986; Garcia and Calantone, 2002; Green et. al., 1995; Henderson and Clark, 1990; Hill and Rothaermel, 2003; McDermott and O'Connor, 2002; Sorescu et. al., 2003). Though existing research agrees that radical innovation is significantly different from incremental innovation, a consensus regarding an explicit definition of radical innovation has not yet been attained. Research has pursued to develop a definition based on different micro- and macro levels regarding radical innovation, see table 1 (Cardinal, 2001; Chang et. al., 2012; Garcia and Calantone, 2002; Henderson and Clark, 1990; Hill and Rothaermel, 2003; Green et. al., 1995; Markides, 2006; McDermott and O'Connor, 2002; Sorescu et. al., 2003). Chang et. al. (2012) suggest that different definitions apply to the different dimensions of innovations; (1) the degree of change in technology and the market, (2) the process of radical innovation, and (3) the impacts on existing products and business. Existing research suggests radical innovation is based on novel technologies or technologies novel to the firm, leading to new markets and customers (Garcia and Calantone, 2002; Green et. al., 1995; Henderson and Clark, 1990; Hill and Rothaermel, 2003). Radical innovation technology incorporates four dimensions; (1) technological uncertainty, (2) technical inexperience, (3) business inexperience, and (4) technology cost. Processes concerning radical innovation tend to be long-term (over 10 years of development), expensive, risky and
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Table 1. Existing research on the definition of radical innovation.
Radical innovation in large firms
Though a formal consensus regarding a clear definition of radical innovation has not yet been achieved, existing research agrees that radical innovation within firms is very important and different from incremental innovation (Assink, 2006; Bers et. al., 2009; Chandy and Tellis, 2000; Chang et. al., 2012; Garcia and Calantone, 2002; Green et. al., 1995; Henderson and Clark, 1990; Hill and
Rothaermel, 2003; McDermott and O'Connor, 2002; Sorescu et. al., 2003; Veryzer Jr, 1998). Koberg et. al. (2003) argue that "radical innovation is specifically important to the economic sustainability of firms that are dependent on competitive research and development for comparative advantage and long-term survival" (p. 22).
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Which ultimately result in large firms lagging behind compared to start-ups (Ansari and Krop, 2012; Benner, 2010; Chandy and Tellis, 1998; Chang et. al., 2012; Christensen, 2013). Chandy & Tellis (2000) suggests three reasons why incumbents tend to hold on to existing frameworks and fail; (1) perceived incentives, (2) organization filters, and (3) organizational routines. Based on the
combination of existing research, Chang et. al. (2012) define five organizational inhibitors that hinder large firms to “recognize, plan, evaluate, organize, and experiment in radical innovation” (p. 442); (1) limited organizational searching, (2) insufficient organizational planning framework and evaluation tools, (3) rigid organizational routines and culture, (4) incorrect staffing, compensation and reward systems, and (5) a reluctance to experiment in unknown territory.
Due to the just mentioned factors, large firms are not able to successfully develop and manage radical innovations. Therefore during the rise of a new radical innovation in the market large firms will struggle or be unable to adjust to the new dominant design. Ultimately resulting in a decline of large firms within the market (Christensen, 2013). This decline could have a major impact on not only the business environment but also the economy. Large firms represent only 0.2% of the total firms in the European Union, yet they cover 33.1% of total employment and 41.9% of the value added generation in the European Union (EU recommendation, 2014).
In addition to the previous mentioned organizational inhibitors of radical innovation, gaining support for radical innovation within large firms often proves to be very difficult. Internal cultures and pressures often push efforts toward more low risk, immediate reward and thus incremental innovation (Ansari and Krop, 2012; Benner, 2010; Chandy and Tellis, 1998; Chang et. al., 2012; Christensen, 2013; McDermott and O'Connor, 2002).
Shareholders influence in large firms
The previous mentioned internal cultures and pressures include the dominant shareholder model and shareholders present within firms. Over the last decades shareholders have gained influence and importance within large firms (Aglietta, 2000; Aglietta and Breton, 2001; Burgers and Heilbron, 2018; Fligstein, 1993; Lazonick and O’sullivan, 2000). Their increased influence stems from a collective power of opinion, motivated by financial markets. Due to the rise of information technologies, financial markets have been able to publicly value firms, explicitly compare firms' return on investment and develop related performance indicators. This has resulted in a corporate governance model in which shareholder value is the norm (Aglietta, 2000; Aglietta and Breton, 2001; Burgers and Heilbron, 2018; Froud et. al., 2000; Lazonick and O’sullivan, 2000).
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focus on reducing labour force, to increase the return on equity (Lazonick and O’sullivan, 2000). Stockhammer (2004) adds that management, in accordance with shareholder preference, has started to choose profit over growth of the firm. In contrast, others argue that due to shareholder influence, management has defined firm growth as main objective (Zorn et. al., 2014).
Second, management’s interests became aligned with shareholders’ interests. This alignment is caused by changes in compensation of management and the potential of negative firm valuation. Currently, management is paid according to firm size and compensated through stock options. Added to that, shareholders lowered the price of firms that did not align management’s interests with shareholders’ interests, while securities analysts recommended against buying stock in those firms. This has resulted in a more sensitive firm management towards financial market valuation and firm growth. (Lacetera, 2001; Stockhammer, 2004; Zorn et. al., 2014).
In addition to influencing firms' strategies and management, shareholders are suggested to influence firms' R&D and innovation (Aghion, et. al., 2013; Benner, 2007; Benner, 2010; Bushee, 1998; Hansen and Hill, 1991; Hoskisson et. al., 2002; Luong et. al., 2017). Within this area of research, there are three different angles of perspective (Kochhar and David, 1996). The first perspective argues that shareholders focus on short-term gains and cause ‘myopia’ within firms ultimately resulting in a decline in competitiveness (Benner, 2007; Benner, 2010; Bushee, 1998; Graves, 1988; Hitt et. al., 1988). The second perspective argues that shareholders focus on long-term gains and thus stimulate more innovative behaviour (Aghion et. al., 2013; Hansen and Hill, 1991; Majumdar and Nagarajan, 1997). The third perspective argues that shareholders act as active monitors for innovation, influencing management where needed (Bushee, 1998; Luong et. al., 2017; Majumdar and Nagarajan, 1997). Table 2 provides an overview of the three perspectives regarding this research area.
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According to the first perspective, existing research suggests shareholders' focus is on short-term financial gains at the expense of longer-term R&D, thus radical innovation. This is further substantiated by the positive financial impact on shareholder returns of incremental innovation projects over radical innovation projects (Mc Namara and Baden-Fuller, 2007). Within this line of perspective, Benner (2010) argues that analysts are more attentive towards large firms’ strategies that extend and preserve existing technologies instead of new technologies. Adding to this, analysts are negative towards strategies that respond directly to new technologies. Since existing research shows that shareholders behaviour is influenced by analysts’ recommendations, Benner (2010) argues that shareholders will follow and invest in large firms which develop strategies based on existing technologies. Yet Bushee (1998) suggests that ‘myopic’ influence is only the case for institutions exhibiting “extremely high levels of transient ownership characteristics” (p. 330). Contrasting to the first perspective, Aghion et. al. (2013) argue that shareholders' presence "boost innovation" (p. 35). Hansen and Hill (1991) add to this that institutional holdings in a firm increase R&D spending. Finally, Majumdar and Nagarajan (1997) argue that shareholders are changing their mind-set from mere investor towards owner, resulting in long-term focused behaviour. Adding to this change in mind-set, shareholders also changed in monitoring and correcting management with regard to long-term strategies (Majumdar and Nagarajan, 1997). Finally, Luong et. al. (2017) find that shareholders stimulate innovation by acting as active monitors. They “provide insurance against innovation failure to management with career or reputational concerns and by promoting knowledge spill-overs from high innovative countries” (p. 1449).
In short, radical innovation is found to be different from incremental innovation. In addition, it is more important for firms' survival and competitiveness in today’s markets. Yet the successful development and management of radical innovations within large firms are not well understood. Large firms experience different organizational inhibitors regarding radical innovation, including internal support. Internal cultures and pressures are suggested to push towards incremental innovations at the expense of radical innovations. The internal cultures and pressures include firms’ shareholders.
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METHODOLOGY
In the previous section, the theoretical base of this paper has been presented. In this section, the methodological approach of the research is provided and discussed on the basis of the design, setting, case selection, data collection and analysis. Collection and analysis have not been performed
individually in the previously mentioned order, some overlap has occurred during the process. Overall this section tries to give a clear overview of the choices made regarding the method of this research.
Research Design and Setting
Research Design.
The theoretical background provided a somewhat diverse pallet of perspectivessurrounding the influence of shareholders on (radical) innovation. In order to deepen the insights surrounding this phenomenon, a qualitative research design was appropriate. Since the research question seeks to answer “how” the phenomenon has occurred, a case study is the appropriate qualitative research method (Yin, 1984). Case study research enables the researcher to join multiple observations, data collection methods and levels of analysis. Resulting in a complete image of the phenomenon (Baxter & Jack, 2008; Eisenhardt, 1989; Noor, 2008). Finally, it enables the researcher to gain insights in the potential complex social processes surrounding the researched phenomenon (Eisenhardt & Graebner, 2007). This research is based on a single case representing the process of shareholder influence within the pharmaceutical industry.
Research Setting. This research takes place within the pharmaceutical industry. Compared to
other industries within the healthcare industry, the pharmaceutical industry has grown the
most in both expenditure and innovation. This growth is mainly caused by the continuous
introduction of new products. P
harmaceutical firms spend 20-30% of their revenues on R&D (Grewal et. al., 2008).12
Case Selection. This study is conducted from a single case. The case represents the process of shareholder influence on radical innovation within large firms in the pharmaceutical industry. This single case is selected in order to provide a complete image of the researched phenomenon by including the different parties involved in the total process. The case is built on interviews with different experts in both the pharmaceutical industry and the financial market. The experts labelled “pharmaceutical industry experts” include (1) (former) CEOs of large pharmaceutical firms situated in the Netherlands, (2) founders of “non-classic” pharmaceutical organizations situated in the
Netherlands, (3) Dutch academics, (4) Unit directors of large pharmaceutical firms situated in the Netherlands, (5) Life-science experts and (6) Life-science investors. The experts labelled “financial market experts” include (1) M&A specialists, (2) Corporate Finance consultants and (3) an audit partner. Table 3 presents the experts and their function. All experts were familiar with the pharmaceutical industry, its shareholder model or policy and its innovation processes1.
Table 3. Overview of interviewed experts and their function.
Data Collection and Analysis
Data Collection. Within this research data was collected from both interviews and secondary
sources. This results in a stronger ground of evidence due to triangulation
(Eisenhardt, 1989; Golafshani, 2003).Secondary sources include insights in innovation initiatives from three large
pharmaceutical firms, analysts’ reports on the pharmaceutical industry, books and press
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articles. The insights in innovation initiatives of AstraZeneca, Takeda and Roche were
conducted from online sources and documented within an Excel document. The Excel
document briefly describes and defines the initiatives according to objective, approach, type
and proximity (technological (knowledge), organizational and market). The case was built on
the above mentioned combination of secondary sources.
In order to gain a deeper understanding of the researched phenomenon
(Eisenhardt & Graebner, 2007), the primary source of data was 14
2semi-structured, in-depth interviews (See Appendix
II-VI). The interviews were conducted in person, over the phone, and through Skype. The
average interview took between 1 hour and 1,5 hours.
Most of the interviews were taped to prevent losing important data. Afterwards, the interviews were transcribed and sent back to the interviewee for feedback and accordance.The structure of the interviews
allowed for follow-up questions designed to probe during interesting issues. Thereby, the structure enabled the interviewees to express themselves openly and freely, describing the phenomenon from their own perspective (Hancock & Algozzine, 2016). The interviews were conducted with different experts in both fields to maintain a complete image of the industry and phenomenon. To maintain a level of verification, similar questions were submitted to the interviewees. These questions often referred to facts or concrete examples or events drawn from the secondary data sources (Cardinal et. al., 2014). Due to the focus of case study research on the history of past and current phenomenon (Leonard-Barton, 1990), data on the case was collected in a retrospective manner. Collecting the data in a retrospective manner allowed the data collection to be more focused on cases that are "likely to replicate or extend the emergent theory" (Eisenhardt, 1989, p. 537). Thereby, the collection of data in a retrospective manner allows for focus and prevents data overload and collection of unusable or insignificant data (Faems, Janssens, Madhok & Looy, 2008). Yet, data collection in a retrospective manner has its disadvantages. According to Faems et.al. (2008), respondents may filter out events that do not fit or make their story less cohesive. Thereby, Miller et. al. (1997) suggest that interviewees are not able to accurately recall the past, influencing the case study. Case study research, in general, is often subject of criticism. Case study research is criticised for its lower reliability, generalizability and potential biases like misjudged representativeness (Bassey, 1999; Leonard-Barton, 1990; Noor, 2008). In order to improve reliability and validity of the study and prevent potential biases, several strategies were used. First, data was triangulated, meaning several data collection methods were used(Eisenhardt, 1989; Golafshani, 2003). Second, within the case, different interviews were held in order to reduce the risk of an unseemly influence of an individual interview on the case study while
providing a more complete picture of the case (McDermott & O’Connor, 2002). Finally, to lower
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potential cognitive bias regarding the interviewees, concrete examples or events were used during the interviews (Miller et. al., 1997).
Data Analysis. The simultaneous collection and analyzation of the data provided flexibility to adjust and add interviews, ask additional questions and add secondary data sources (Eisenhardt, 1989). The data were analysed using an inductive approach as provided in the work of Gioia et. al. (2013), starting at 1st-order analysis and 2nd-order analysis, resulting in aggregate dimensions (See Appendix VII). During the 1st-order analysis, categories were formed based on interviewees’ terms and
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Figure 1. Data Structure based on the model of Gioia et. al. (2013)
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Figure 1. Continued; Data Structure based on the model of Gioia et. al. (2013)
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FINDINGS
In this section, all relevant findings are presented. The data structure of the relevant findings is provided in figure 1. The findings are presented in the following way; first, shareholders’ willingness to invest in pharmaceutical firms is explicated. Second, the shareholder model as the dominant model within pharmaceutical firms is clarified. Third, insights within the changes in R&D context of pharmaceutical firms are given. Fourth, the process of mutual influence is presented resulting in implications for pharmaceutical firms' radical innovation. Finally, a conclusion is presented in which the findings are related to the research question.
Shareholder’s willingness to invest in pharmaceutical firms
The pharmaceutical industry is considered a complex industry where both risks and investments are high. This complexity reflects on the investment decision process. During this process, two aspects play a role; shareholder’s characteristics and firm value. Shareholder’s characteristics include
shareholder’s goal, motivation and desired optimal return. Firm value is determined by the firm value as dictated by the financial market and shareholder’s own value perception. If shareholder’s
characteristics meet those of a potential firm and the perceived firm value is positive, a shareholder is willing to invest in a firm. In the following section the process of firm valuation, shareholder's characteristics and how these influence shareholder's willingness to invest is presented.
Until the 21st-century pharmaceutical firms enjoyed sky-high sales, profits and growth margins. Due to this performance, pharmaceutical firms attracted shareholders who were focused on generating
maximum financial returns on their investments. “There is a reason why so many shareholders invest in pharmaceutical firms. It is an industry which has proven itself for decades.” (09052018, p. 4). Although the main goal of every shareholder is the generation of maximum return, dependent on the motivation of the shareholder, the previously mentioned return could also be of social nature. "The desired return can also be a social return, like solving a disease" (31032018, 2018).
Shareholder’s motivation is connected to the shareholder type. “(…) in recent years it has often occurred that charities invest in research on behalf of patient groups (…) the charities are working to get a better grip on development processes by acting as an investor.” (E. van der Meer, personal communication transcript, April 18, 2018). Despite the fact that most shareholders are large investment funds, a rise of charities as shareholders within pharmaceutical firms can be observed. Compared to the large investment funds their motivation for investment differs. Where this type of shareholder’s optimal return is social, most large investment funds’ optimal returns are financial. The difference in motivation defines shareholder’s attitude towards risk and ultimately influences
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Although the pharmaceutical industry has performed very well, it has always been characterized by its highly technological character, lack of transparency, and long R&D processes, containing high risks and high investments. Considering this complexity of the pharmaceutical industry, shareholders take several aspects into account before deciding to invest. These aspects are used to determine firm's value and are mainly calculated by analysts.
Large firm valuation is based on; (1) revenue development, (2) current R&D projects and potential success, (3) potential future product success and (4) management reputation.
First, revenue development is based on past revenues, current revenues and potential future revenues. By comparing past revenues with current revenues, business analysts are capable to calculate the development of firm’s revenue, which is either positive or negative. Positive revenue development and positive potential future revenues positively impact firm’s value.
Second, additional to revenue development, firm value within the pharmaceutical industry is influenced by current R&D projects and their potential success. Analysis is based on firm specific R&D projects present within its pipeline and its potential success which is based on the following factors; (1) management capability, (2) track record, (3) R&D quality (4) patents & future markets and (5) current phase. In order for an R&D project to succeed, management of the project should be competent as shareholders tend to value a good management team over the quality of the technology developed.
“Management quality is often more important than technology (…) if potential shareholders could choose between a poor management team combined with a good technology versus a good management team combined with a poor technology, they will choose the latter option.” (31032018, 2018).
Next, to the quality, management’s track record should show past successes. “If a firm is able to show successful R&D projects in the past, any future R&D projects have a greater chance of
succeeding.”(06042018, 2018). The ability to show a successful track record therefore positively influences both R&D project success and firm value. Further, R&D project success is based on the R&D quality. R&D quality consists of the people and resources needed for the R&D project.
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IP being refused.” (31032018, p.3). Finally, R&D project success is dependent on the phase in which the project is located. R&D consists of two main phases; (1) pre-clinical phases and (2) clinical phases. “The higher the phase of development, the higher the potential success of the R&D project.” (06042018, p. 2).
Some overlap occurs between R&D project success and overall firm value analysation. Both are partly based on future markets and patents in order to determine future product success and markets.
Thereby, both focus on management’s reputation.
Overall, large pharmaceutical firms’ shareholders are large investment funds who’s motivation is to generate optimal financial returns. Their increased power and importance within the industry led to the current dominant shareholder model within large pharmaceutical firms. It is suggested that these types of shareholders have an aversion towards high risk. Due to their suggested aversion towards high risk in combination with their increased power and importance, they have been able to influence firm’s management.
The Shareholder Model
Due to the extent of shareholders willing to invest in pharmaceutical firms the current dominant shareholder model has emerged. Shareholders’ increased power and importance enabled them to influence management through the creation of shared commercial interests and the ability to assign management. This influence caused management to become experts in managing shareholder value at the expense of industry specific expertise. The pressure to perform financially and achieve optimal shareholder value has led management to develop shareholder driven performance indicators to monitor overall firm performance. These performance indicators are mostly revenue, profit, sales and growth driven. The following section presents insights into the shareholder model, shareholder value driven management and shareholder driven performance indicators as present in today's large pharmaceutical firms.
Within the pharmaceutical industry, “the largest part of the pharmaceutical firms, around 90%-95%, is shareholder driven.” (H. Büller, 2018). The shareholder model relates performance to shareholder value, based on shareholder returns, and firm value, as set by the financial market. Once invested in pharmaceutical firms, shareholders focus on sales and profit maximization in order to generate optimal financial returns. "(…) shareholder focus has created a focus on potential sales instead of a market- or patient need" (F. van Dongen, p. 4, 2018)
Over the years, the power of shareholders within large pharmaceutical firms has increased as well as their importance. Price became an objective within this model. “Within the industry, we are fully focussed on PxQ and for the highest possible price. It is embedded in our economy” (B. van der Mierden, 2018).
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Crossing your shareholders is not done and could lead to loss of investments and decreased firm value. In the pharmaceutical industry, firms are dependent on investments, so potentially losing it could have catastrophic consequences. As a result management of large pharmaceutical firms changed under the influence of shareholders.
“The management of pharmaceutical companies has also changed through shareholder capitalism. Management has received a completely different focus. To begin with, the management is also paid in shares and options, so they have the same interest as the shareholders. (…) Thereby, management is often chosen by shareholders, resulting in a management team with the same interests or visions. (…) As a result, managers in pharma are now experts in achieving shareholder value at the expense of expertise in the pharmaceutical field. (…) In addition, what they manage nowadays is no longer that ‘pill’, so to speak, but the shareholder value” (J. Burgers, 2018).
The focus on shareholder value and the shared commercial vision changed management’s strategies, aiming for sales, profits and firm value. In addition, this resulted in different performance drivers. Performance drivers in current large pharmaceutical firms have a commercial nature and are
developed to analyse performance, based on contribution to shareholder value at the expense of real medical needs. Resulting in strategies with a commercial goal instead of a medical goal.
“(…) Ipsen has set the goal of achieving at least one major product introduction or at least the introduction of a new indication of a large existing product per year. Under large, the organization assumes a minimum, potential value of $100 million per year” (F. van Dongen, p. 2, 2018).
Priority shifted from medical returns to commercial returns. Commercial potential currently outweighs real medical need. This is observed in several large pharmaceutical firms. Take the example of Pfizer. “At Pfizer it was decided, at the time, to stop research into cardiovascular diseases. Pfizer (…) saw no further potential in this clinical field. This potential has to do with a medical need on the one hand, but also with commercial potential. (…) After deciding to no longer invest in cardiovascular diseases, Pfizer decided to invest in Alzheimer's R&D. But, they recently decided to stop R&D within that specific clinical field as well. Apparently, it did not achieve the commercial potential, since a medical need is still present” (09052018, 2018).
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innovation focus is on commercial innovation and generating sales at the expense of long-term radical innovation projects.
“(…) the head office nowadays also encourages innovation in the commercial field. (…) Given that the local units are often sales units and the pressure to achieve results in the short term is high, you often see situations arise in which there is a lot of pushing to sell "pills" or at least bring costs down. As a result, there is less or no focus on long-term radical innovation projects that are likely to improve your position in the future more than a short-term strategy” (F. van Dongen, p.5, 2018).
The increased power and importance of shareholders within large pharmaceutical firms has led to the current dominant shareholder model. Shareholders have been able to influence firms’ management by creating shared commercial interests. Management’s vision changed from medical needs towards financial needs, creating new performance indicators. The changed vision on performance created a changed vision on innovation, impacting and changing the R&D context.
Change in R&D Context
The focus on sales and lowering risks, in combination with an overall industry shift from "blockbusters" towards " orphan diseases" led to more protocolled R&D processes. In order to generate synergy and efficiency within R&D, firms chose several specific clinical paths or treatment areas. With this choice, the divestment of R&D started. This divestment resulted in the transformation of large pharmaceutical firms from research & development firms into search & development firms, who strategically acquire external innovations. The pressure of financial driven performance indicators led to a commercial focused R&D, resulting in a decreased interest of value chain parties to
collaborate. The following section provides insights in the changed R&D context resulting from the overall industry shift from “blockbusters” to “orphan diseases”, the transformation of pharmaceutical firms from R&D to S&D and the decreased interest of value chain parties to collaborate.
The changes brought along by shareholder focused management was not the only factor leading up to changes surrounding radical innovation and R&D. Although the shareholders played a major role, the change was also due to a change of era within the pharmaceutical industry.
The wealth that attracted the shareholders until the 21st century, was mainly due to “Blockbusters”. The “blockbuster” medicines were medicines who individually generated at least $1 billion per year. “Every large pharmaceutical firm was searching for “blockbusters” and had at least a couple within its portfolio” (09052018, p. 1). The “blockbuster” medicines were developed to treat diseases or
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A lot of these “blockbuster” medicines were discovered by lucky coincidence. During this period R&D departments of large pharmaceutical firms were free to “play around” (09052018, p. 2) and got offered the room and the opportunity to do certain discoveries. “The R&D departments at the time were simply pioneering (…) Due to this structure of R&D, medicines like Viagra were discovered.” (09052018, p. 1).
Around the start of the 21st century, a small shift started to occur. The majority of the mass market diseases were solved, which ended the “blockbuster” period and started the “orphan disease” period in which the industry is today. Markets connected to “orphan diseases” were much smaller compared to the “blockbusters’” and therefore contained higher risks. The industry changed and impacted the pharmaceutical industry, pharmaceutical firms as well as its shareholders.
During the “blockbuster” period shareholders and firms became accustomed to high profit margins and growth.
“We have become accustomed to growth. The moment a company does not grow, we panic. No growth is automatically shrinkage and shrinkage is unattractive for shareholders. This focus on growth might be at the most extreme in the pharmaceutical industry.” (F. van Dongen, p. 3).
Although costs of R&D mostly remained the same, the smaller markets resulted in relative higher R&D costs of new medicines, jeopardizing profit margins and thus shareholder returns within pharmaceutical firms.
The shift from “blockbusters” to “orphan diseases” created a number of problems for the dominant shareholder model within the industry’s firms. First, it created problems with regard to the investment process surrounding radical innovation. Second, it created problems within R&D processes due to increased risks and relative investments. In order to solve these problems management of large pharmaceutical firms has developed several strategies in order to lower risks and maintain shareholder value.
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shareholders are inclined to invest in later stages, creating an increasing investment gap between ‘idea’ and investment.
The second problem threatening the dominant shareholder model occurs within firm’s R&D processes. Increased risks and complexity have not only influenced the investment process. It has influenced internal R&D processes as well. Management's felt pressure to financially perform under these new circumstances has resulted in new and rigorous R&D strategies. These new strategies aimed to lower risks and potential innovation development failures, in order to maintain shareholder value.
A striking result of these strategies is observed within the R&D context of large pharmaceutical firms. "Within pharmaceutical firms, the costs of R&D are about 17%-20% of total revenues. What has happened in recent years, due to the developments that have occurred in the industry, is the disposal of R&D within firms. The argument for this is that the divestment of the R&D increases shareholder value by the aforementioned percentage that is saved by the company" (J. Burgers, p. 1, 2018).
R&D divestment is a result of firms’ strategies to lower risks and potential failures in innovation development. These strategies created specialised firms, operating in a few specific clinical areas. Focus on core activities creates synergy and efficiency, yet it results in a more narrow scope of R&D and radical innovation. These narrow portfolios make firms more vulnerable in case of potential failures.
The divestment of R&D not related to the specific clinical areas not only made firms more vulnerable, it also resulted in the loss of expertise. "Due to cancellation of these projects, a lot of knowledge disappears from the organization" (09052018, 2018). The divestment of in-house R&D and the decrease of internal knowledge have resulted in the replacement of innovation within knowledge institutes and start-ups, narrowing the scope of knowledge and (radical) innovation within large pharmaceutical organizations. "Especially radical innovation is currently taking place within publicly funded projects and institutions" (J. Burgers, 2018).
“With the rise of start-ups and the shift of knowledge outside large pharmaceutical firms another model within the pharmaceutical industry developed. The model of ‘search & development’. Large pharmaceutical firms started to buy these start-ups” (09052018, 2018).
This new model increased shareholder value by saving costs invested in in-house R&D. Thereby, it decreased potential risks connected to R&D caused by failures, while increasing overall innovation process efficiency, especially radical innovation. Radical innovation is currently taking place in public funded knowledge- and research institutes.
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a very smart way of doing business, initiated by shareholder pressure to generate maximum profits and sales” (P. Kapitein, p. 5, 2018).
The changed R&D model let to a total new mind-set within large pharmaceutical firms. “The mind-set of pharmaceutical firms has changed from development to acquisition” (H. Büller, 2018). Large pharmaceutical firms are actively searching for potential interesting radical innovation projects present within start-ups in the life science market. “They are hanging above a field as a bird of prey, picking out the interesting projects here and there. (…) As a result, the percentage of failures decreases and the purchase of a start-up, if successful, also lowers risk” (H. Büller, p. 1, 2018).
This model also has its disadvantages for large pharmaceutical firms. “(…) it has a negative effect on radical innovation for the large pharmaceutical organizations. It increases the dependence of the organization on the collaboration with start-ups” (F. van Dongen, p. 5, 2018).
Under the new industry circumstances, shareholder focused management transformed large pharmaceutical firms from R&D driven organizations into Search & Development organizations. Reducing internal R&D, especially focused on radical innovation, made firms more dependent on public funded institutes and start-ups.
For R&D processes that remained within the firm, risk lowering strategies went further. Where R&D departments were previously free to “play around” and research in an unstructured way, the
specialization and risk lowering strategies resulted in more protocolled R&D processes. “Reducing these risks also takes place in testing the innovation or the new product on the potential patient group” (F. van Dongen, p. 4, 2018).
As discussed in the firm valuation section, R&D is divided into two phases (1) Pre-Clinical and (2) Clinical. In the clinical phase, scientists start to research the safety and effectiveness of the potential medicine on human beings. In the current industry, pharmaceutical firms need a trade registration from the European Medicine Agency (EMA) before they can enter the market with their new medicine. In order to get a registration for the new medicine, the clinical trials should primarily demonstrate effectiveness. Yet, the smaller patient pool connected to “orphan diseases” makes testing the new potential medicine very difficult. “When the medicine is ready to be tested on patients in clinical trials it is much more difficult to include patients due to the smaller size of the patient pool. This, in turn, has consequences for the statistical strength of the research, which is necessary for registration of the medicine” (09052018, 2018).
Whether this relates to the overall patient pool or the desired patient pool is an ongoing discussion. It is common knowledge within the pharmaceutical industry that specific inclusion criteria are used during clinical trials. The underlying motivation and result of these criteria are subject to discussion. One of the interviewees states that the inclusion criteria indeed cause a non-representative image of the effectiveness of the new medicine on patients, yet due to the demonstrated effectiveness during
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number. Testing on a representative group could have led to a rejection of a potential registration, thus resulting in no successful treatments at all. The interviewee agrees that besides the successful
treatment of some patients, the registration also leads to higher shareholder value. “Instead of testing on a representative group, it is tested on the group where it is known that effectiveness is optimal and thus the chance of registration is higher, which ultimately promotes sales and thus keeps shareholder value high” (F. van Dongen, 2018).
In general, the dominant vision regarding the cause of inclusion criteria is the pressure of the shareholder model and shareholder focused management. Kapitein (2018) supports this vision. He explains that inclusion criteria lead to a faster and more efficient registration, yet lead to the exclusion of patients in need and a decrease in innovation quality. “When a new medicine is being developed and tested, inclusion criteria are used to select patients for the trial. What is disturbing about these criteria is that most patients on which the new medicine is tested during trials are often not
representative of the total patient group” (P. Kapitein, p. 1, 2018). A major difference between the patient pool in clinical trials and the real patient pool is the average age. The importance of the age difference has to do with coping mobility of older patients. Peter Kapitein (2018) explains.
“Next to the fact that the average age of patients in the trial is lower, there is a difference in coping mobility. Older patients often have other ailments and diseases besides cancer, due to age. Thus, increasing risk that the new medicine will not be as effective and the phase 3 will be unsuccessful. This could cause the new medicine to fail and failure costs a pharmaceutical company and its shareholders a lot of money” (P. Kapitein, p. 1-2, 2018).
A final development within firms’ R&D context caused by the shareholder model is the increased transaction or financing costs of medicine development. Around 50% of total development costs are transaction costs paid to shareholders at the end of every successful development phase. These high transaction costs result in the extremely high prices of, especially, radical innovation.
To sum up, current shareholder focused management leads to a changed focus on innovation and corresponding R&D processes. Pressure on R&D times, risks and potential innovation failure have led to more protocolled R&D processes. A major influence is found in the use of inclusion criteria, which are focused on achieving the highest possible effectiveness in order to gain registration and access to the market. “So under pressure of the system (or shareholders) particular inclusion criteria are set for trial research to increase chances of success, registration and thus a potential new product launch (…) Causing a drop in effectiveness when used on the real patients” (P. Kapitein, p. 2, 2018). Driven by commercial interests and innovating for sale expansion large pharmaceutical firms become less interesting collaboration partners for other parties within the value chain.
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most effective product or innovation” (B. van der Mierden, p. 3, 2018). Due to a strong internal focus and focus on developing radical innovations with the highest financial potential instead of highest medical need, large pharmaceutical firms have become less attractive for other value chain parties to collaborate with.
The general opinion on large pharmaceutical firm reputation is rather negative and large pharma is well aware. “Pharmaceutical companies are seen as the ‘necessary’ evil. We are seen as companies who only focus on sales, who offer overpriced products (especially the radical innovative ones) and who ‘over-treat’ patients” (F. van Dongen, p.1, 2018).
This reputation differs per geographical region and culture, even within the Netherlands. "In the south of Europe, this relationship is completely different. There you are seen as a (business) partner. (…) Calvinists (North part of The Netherlands) have a more negative attitude towards pharmaceutical organizations than the Catholics (South part of The Netherlands)” (F. van Dongen, p. 1-2, 2018).
Despite the decreasing interest of value chain parties to collaborate, there is interest to collaborate from the side of the large pharmaceutical firms. Reasons to collaborate include; (1) getting access to specialists, for example, oncologists, in hospitals, and (2) product improvement. First, specialists are difficult to approach outside of cooperation. One of the interviewees states “Oncologists in a hospital are difficult to approach for our firm outside collaborations” (F. van Dongen, p. 1, 2018). Second, large pharmaceutical firms seek collaboration to improve their products; “By means of collaborations, you want the treatment of the patient to be measurably improved” (F. van Dongen, p.2, 2018).
The first mentioned reason to collaborate in combination with large firms’ general negative reputation, decreases collaboration interest of other value chain parties. It has resulted in a general lack of trust and understanding among the different parties. In addition to the previously mentioned reason, there are other reasons for the decrease in collaboration interest.
First, the mind-set of large firms compared to other value chain parties differs. Where large pharmaceutical firms are shareholder focused, resulting in a commercial mind-set, the mind-set of other parties “(…) is built on a collective vision, solidarity and price as part of the quality” (B. van der Mierden, p. 2-3, 2018). According to the interviewee large pharmaceutical firms work according to a value-based model, aimed at registration before effectiveness which clashes with the other parties’ models.
27 Kapitein, p. 1, 2018).
Finally, the internal focus and non-stakeholder involvement lead to a decrease in collaboration interest. “In the current situation, in the current system, two very important groups are not included in the innovation process. (…) the people who ultimately receive it, the patients, and the people who have to work with it, the medical specialists” (B. van der Mierden, p. 3, 2018).
Due to the differences in vision with regard to innovation, large firms’ developed innovations or innovation initiatives are not implemented by the value chain. “Due to the focus of the shareholder model on sales and profit maximization, the innovations that are made are seen as non-important and are not implemented. This is the biggest problem for innovation” (B. van der Mierden, p. 3, 2018). Failure to generate trust and understanding between the large pharmaceutical firms and value chain parties decreases collaboration interests from the value chain parties’ side. The commercial focus of large pharmaceutical firms results in non-important and ineffective innovations in the eyes of value chain parties. The difference in vision ultimately results in non-implementation of radical innovations developed by large pharmaceutical firms within the value chain. “Failure to interlock the models leads to less qualitative radical innovations and a real innovation stop” (B. van der Mierden, p. 3, 2018).
DISCUSSION & CONCLUSION
The following section will provide a discussion and conclusion based on the findings. In this section, the study seeks to provide an answer to the research question: “How do shareholders in large pharmaceutical firms influence radical innovation?”.
First, a process model visualizing the influence of shareholders within large pharmaceutical firms on radical innovation is defined. Second, the findings will be related to existing literature, providing theoretical implications, after which practical or managerial implications are discussed. Finally, any limitations regarding this study are provided followed by suggestions for future research.
Process Model
Shareholders do not directly influence radical innovation within large pharmaceutical firms.
Shareholders have an influence on the total radical innovation process, impacting different firm levels before reaching radical innovation. The process of influence of shareholders on radical innovation will be discussed, after which the process model will be presented.
How does the influence of shareholders flow through the firm before finally impacting radical innovation? The process starts with the willingness of shareholders to invest in a specific large
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creating shared commercial interests. The assignment of management and the creation of shared commercial interests changed management’s vision and focus. Management became experts at managing shareholder value by determining performance according to revenue, profit, sales and growth. This changed focus led to strategies aimed for efficiency. For internal R&D, these strategies resulted in the focus on specific clinical paths and the divestment of internal R&D, resulting in a narrow scope of radical innovations. Due to the reduction of R&D, internal knowledge was lost and replaced within public funded institutes and start-ups. These developments created a new radical innovation model, in which large firms acquired radical innovations instead of developing them. This new model has placed radical innovations outside large pharmaceutical firms. Remaining internal R&D processes became more protocolled in order to reduce risks. The commercial performance indicators which also applied to R&D resulted in a decreased interest of value chain parties to cooperate with large pharmaceutical firms. This decrease in cooperation has resulted in ineffective innovations since important stakeholders were not involved in the development process and thus non-implemented radical innovations. Besides a decrease in cooperation interest, commercial performance indicators in R&D have led to radical innovations with a commercial character over a medical
character. Finally, shareholder focused management and the pressure to perform financially has led to high transaction costs within radical innovation development, resulting in extreme prices. The process model visualizing the previously presented process of influence is defined below.
Figure 2. Shareholder influence on radical innovation process, based on Gioia et. al. (2013).
Implications
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However, this study contributes to the current literature by providing insight into the flow of
shareholders' influence through different levels. The model provided in this study, therefore, provides an overview of shareholders' influence including the different levels involved rather than focusing on separate or several levels.
This study is in line with the view of Benner (2010) regarding the influence of business analysts and firm value as defined in the financial market of shareholders’ investment decision. However, this study provides deeper and more specific insights in the factors influencing firm’s value. In addition, the findings within this research compliment the view of Stockhammer (2004) arguing the increased focus on profits within firms. Yet, this study does not suggest the major importance of profit over growth. Finally, the view of this research shows similarities with the study of Lazonick and O’sullivan (2000). According to their study shareholders’ influence has led to a changed vision of strategy, resulting in a strategy of ‘downsize and distribute’ to increase return on equity. However, this study goes further by providing the impact of this strategy on R&D context and ultimately radical innovation. The overall findings position this research in line with the ‘myopic’ vision.
Although this study has been derived from a single case, managers are able to derive some
implications. In current media, the influence of shareholders on corporate management and innovation is visualized as being very direct. Yet, this study shows that the influence of shareholders in firms and on radical innovation is less black and white as one might think. The influence of shareholders on radical innovation within pharmaceutical firms is more nuanced. This study provides insights for managers in the whole process of influence on radical innovation and the different parties and factors involved. It showed that there is no direct influence of shareholders on radical innovation, yet a flow of influence through firm’s management, strategies and actions. According to these insights, managers' vision towards the influence of shareholders could become more nuanced. Finally, the overall process of influence could provide innovation or R&D managers with the knowledge of the presence of different motivations of the different parties involved. It, therefore, provides a tool to determine which parties to involve or appeal during the radical innovation process in order to stimulate radical
innovation.
Limitations and Future Research
Although this study has highlighted some interesting findings, this study has its limitations. The research included a broad scope of experts regarding the studied phenomenon. Yet an important expert group within this study is lacking, the shareholder. Due to confidentiality, this type of expert was not willing to contribute to the study, resulting in a potentially biased data set. Yet, in order to recover from this potential bias, business analysts and a seed investor have been involved in the study. Potential future research should, therefore, try to include shareholders.
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research tests the process model before applying in other industries. Third, the study covers a single case. The use of one case could increase chances of observer bias and decrease validity (Leonard-Barton, 1990, p. 250; Yin, 1984). Future research should provide multiple cases in order to improve this. Finally, due to the experienced closed nature of the pharmaceutical industry regarding the researched phenomenon, relevant information might have been excluded from the study. The
experienced closed nature and potential loss of relevant information presumption result from negative responses of shareholders regarding participation in the research and the withdrawal of one of the interviewees.
The findings suggest a difference in shareholder types. It is suggested that different types of shareholders have different motivations of optimal returns, namely financial versus social. A final suggestion for future research is to study the influence of different types of shareholders on radical innovation within large firms.
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