The Biotech Social Contract as it Relates to VC investment in Biotechnology/Pharmaceutical Innovation
The biotech social contract describes the ecosystem and responsibilities of the U.S. biopharmaceutical industry to provide society with new and better medicines that will end up as generic drugs.
The biotech social contract describes the ecosystem and responsibilities of the U.S. biopharmaceutical industry to provide society with new and better medicines that will end up as generic drugs.
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The concept was developed by Peter Kolchinsky (a founder and Managing Partner of RA Capital and author of The Great American Drug Deal). It explains how the industry balances the need for high-risk investment in innovation with long-term affordability of drugs.
It is based on the ability of companies to sell novel, branded drugs under rights of exclusivity at high prices for a set number of years, after which time they must “go generic” and compete on price in the market. For context, prescription drugs represent <10% of healthcare costs (Figure 1), while other expenses, like hospital care and physician services, make up the bulk of spending. This is partly explained because 80-90% of the drugs prescribed are generic, but there are no generic versions of other services, which only increase in costs over time. |
Figure 1
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Key Elements of the Biotech Social Contract
- Incentives for Innovation: Drug profits do not just recoup the baseline costs of manufacturing and commercializing any single given product. More importantly for the ecosystem, high branded drug prices provide pharmaceutical companies with enough cash to pay back the early capital investments and talent that undertook the lengthy early-stage drug discovery risks, which incentivizes future R&D.
- Generic Transition: After exclusivity ends, competition from generic manufacturers should drive prices down dramatically (~80-90%!), ensuring affordability.
- Societal Benefit: The contract assumes universal insurance coverage without high out-of-pocket costs, promoting adherence and preventing financial barriers to care.
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Given this framework, the biopharmaceutical industry operates like a conveyor belt: New branded drugs (which drive most industry revenue despite comprising a minority of prescriptions) fund ongoing R&D, while generics (which dominate prescriptions by volume) keep overall drug spending sustainable (Figure 2).
The contract's value lies in its long-term math: the finite high cost of a branded drug is offset by its potentially infinite benefit as a generic, benefiting not just current patients but society at large through improved health and productivity. |
Figure 2
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Challenges and Proposed Fixes
The biotech social contract breaks down when companies exploit loopholes in the system, such as delaying generics through excessive patents or "price-jacking" (sudden hikes on old drugs without improvements), which erodes trust and costs society billions in lost savings.
Generic competition works well for small-molecule drugs but faces challenges with complex biologics, where biosimilars are slower to enter the market. For advanced therapies like gene editing, where true generics may be impossible, Kolchinsky suggests "contractual genericization," where manufacturers must produce the drug at near-cost after exclusivity.
The biotech social contract breaks down when companies exploit loopholes in the system, such as delaying generics through excessive patents or "price-jacking" (sudden hikes on old drugs without improvements), which erodes trust and costs society billions in lost savings.
Generic competition works well for small-molecule drugs but faces challenges with complex biologics, where biosimilars are slower to enter the market. For advanced therapies like gene editing, where true generics may be impossible, Kolchinsky suggests "contractual genericization," where manufacturers must produce the drug at near-cost after exclusivity.
The PBM Problem
One of the biggest challenges facing the biopharmaceutical ecosystem however, comes from the behavior of intermediaries in the U.S. prescription drug supply chain called Pharmacy Benefit Managers (PBMs) that sit between drug manufacturers and patients.
They were initially set up to lower drug prices by negotiating rebates. And they have been tremendously successful at this, obtaining rebates up to 50% or more of a drug's list price. They are also responsible for designing insurance formularies (the lists of drugs allowed to be covered by insurance for each indication) and contracting with pharmacies to sell drugs.
Unfortunately, individual rebates are confidential and PBMs are allowed to keep the majority of the discounts rather than passing them along to patients. They are therefore motivated to allow list prices to increase, which they keep as additional rebate profit.
Because PBMs set drug formularies, manufacturers are forced to increase the list prices and provide large rebates in order to ensure their products are actually included in formularies and covered by insurance companies. And since out-of-pocket costs are calculated based on list prices, patients end up paying more than they would otherwise. PBMs get away with these practices because there are very few of them (the "Big 3," CVS Caremark, Express Scripts, and OptumRx control ~79% of claims for 270 million people), much of what they do is confidential, and they are vertically integrated with insurers and pharmacies.
Drug list prices are commonly misunderstood. Proposed reforms in the U.S. include faster FDA approvals for generics/biosimilars and closing patent abuses. Insurance reforms are key and would need to provide complete coverage of all Americans, cap out-of-pocket patient costs, and bring transparency to drug prices versus costs.
One of the biggest challenges facing the biopharmaceutical ecosystem however, comes from the behavior of intermediaries in the U.S. prescription drug supply chain called Pharmacy Benefit Managers (PBMs) that sit between drug manufacturers and patients.
They were initially set up to lower drug prices by negotiating rebates. And they have been tremendously successful at this, obtaining rebates up to 50% or more of a drug's list price. They are also responsible for designing insurance formularies (the lists of drugs allowed to be covered by insurance for each indication) and contracting with pharmacies to sell drugs.
Unfortunately, individual rebates are confidential and PBMs are allowed to keep the majority of the discounts rather than passing them along to patients. They are therefore motivated to allow list prices to increase, which they keep as additional rebate profit.
Because PBMs set drug formularies, manufacturers are forced to increase the list prices and provide large rebates in order to ensure their products are actually included in formularies and covered by insurance companies. And since out-of-pocket costs are calculated based on list prices, patients end up paying more than they would otherwise. PBMs get away with these practices because there are very few of them (the "Big 3," CVS Caremark, Express Scripts, and OptumRx control ~79% of claims for 270 million people), much of what they do is confidential, and they are vertically integrated with insurers and pharmacies.
Drug list prices are commonly misunderstood. Proposed reforms in the U.S. include faster FDA approvals for generics/biosimilars and closing patent abuses. Insurance reforms are key and would need to provide complete coverage of all Americans, cap out-of-pocket patient costs, and bring transparency to drug prices versus costs.
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For a deeper dive on stakeholders and dynamics within the biotechnology industry and U.S. Healthcare system we recommend the following courses:
https://racap.thinkific.com/courses/biotechunveiled https://www.outofpocket.health/courses/healthcare-101-crash-course And finally, here is William E. Flanary’s humorous take on PBMs stranglehold on drug pricing in the U.S. https://www.youtube.com/watch?v=5rw4kNHNZyk National Health Care Spending In 2022: Growth Similar To Prepandemic Rates |
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