The proliferation of small biotech companies and the need for industry consolidation has moved beyond cliche to the realm of humor: merely putting the two thoughts together in a sentence is enough to elicit a knowing chuckle from old-timers in the industry.

Nevertheless, logic finally may have reared its head in at least one important corner of the industry: drug discovery. For the past two or three years, the proliferation of companies designed to peddle pieces of the drug discovery process to the pharmaceutical and biotech industries - gene discovery, functional genomics, high throughput screening, combinatorial chemistry - has raised red flags about the business models for these companies. The spectre of dozens of companies each vying to build a sustainable business from royalties based on the "R" piece of R&D defies logic.

ArQule Inc. President and CEO Eric Gordon has spent several years refining a model of the four components that go into the operating margin on product sales: research, development, manufacturing, and marketing and sales. He estimates that pharma companies are looking for operating margins of at least 45 percent, excluding the R&D component. So if they spend, say, 15 percent on R&D, they end up with 20 percent after tax. "Then they work backwards and see what they can afford to pay," he said

The numbers he has worked out are as follows: on average, big pharma pays 12 percent for research, 9-10 percent on development, 18-20 percent on manufacturing, and 4-5 percent on marketing and sales

Key for drug discovery companies is the research portion, which is split about evenly with 6 percent going for biology and 6 percent for chemistry. "When I was at Pasteur Merieux, we said the most we would pay for a gene pool on the biology side was 3 percent," he said. "So if we needed six genes, we divided that into the 3 percent." That 3 percent is the target identification half of biology; the other half includes work such as animal studies and assay development.

Even with single-digit royalty rates, it's hard to make the numbers work if four or five companies each want a 5 or 6 percent royalty just for research: 5 percent adds up to a cumulative 20-25 percent for the discovery phase of drug development, which Gordon's calculations say is too much. And if certain companies can command these rates - and ARQL's five large company collaborations and nine biotech collaborations say they can - that leaves an even smaller royalty pie for the remaining companies.

One piece isn't viable

Based on these numbers, a growing group of drug discovery companies don't believe that it's possible to build a viable long-term business with only one piece of technology