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Jason McIntosh, a production technician at Eli Lilly and Co., examines Cymbalta 60mg pills in Indianapolis, in this Jan. 25, 2006, file photo. The U.S. compound patent on Cymbalta expires in June, 2013.DARRON CUMMINGS/The Associated Press

The pressure to innovate – and to combat disruption – has a lot of big companies looking for ways to harness the agility of smaller firms.

While the pharmaceutical industry is not facing the same difficulties as other sectors, companies are scrambling to discover and develop new drugs, and they're increasingly using strategic investments in smaller businesses to do it.

"The pharma guys have come to a big cycle in the last five years where a lot of products are coming off patent," says Peter Van Der Velden, managing general partner of Lumira Capital, a venture fund that specializes in investments in life sciences and medical technology firms. He says it has caused "game-changing drops in revenues," and it is forcing pharmaceutical companies to think creatively.

The use of capital funds to finance research "is a growing focus," says Elaine Sullivan, vice-president of global external research and development at Eli Lilly and Co., a multinational based in Indianapolis.

While Eli Lilly does traditional investments in small biotech and life sciences companies, it has also developed a new investment model using a subsidiary called Chorus. Unlike a traditional pharmaceutical company, Chorus works with venture partners to identify potential drugs that are in very early stages of research at universities and in startups. If a potential drug is identified, and an investment is made, Chorus – along with the venture partners – helps the company create a plan to take the product through human testing to proof of concept.

Chorus is organized along "lean" lines, Ms. Sullivan explains, drawing influence from small biotech startups, which she says allows the business to "answer the core questions quickly."

"It's a much more nimble and agile group" because Chorus operates independently, says Jennifer Laird, Eli Lilly's director of global external research and development. "The mindset is very entrepreneurial."

Eli Lilly recently established a Canadian branch of Chorus as part of a deal with Teralys Capital and TVM Capital to establish a $150 million Montreal-based venture fund called TVM Life Science Ventures VII. The fund made its first investment in January in Kaneq Bioscience, a Montreal-based company that is working on a treatment for diabetes.

Ms. Laird says two-thirds of the TVM VII fund is ear-marked for investment in "project-focused companies" that are developing a single drug. These companies are usually spun off from another small life-science company or they are created to continue research and development on a potential drug discovered in an academic setting. The other third of the money will be used for traditional investments in small life-science companies.

Venture capitalists say they're also seeing more early stage investment from pharmaceutical companies. "Half of our portfolio already has a (pharmaceutical company as a) strategic investor right in from day one," Mr. Van Der Velden says, adding this is a "huge change" from 10 years ago when strategic investors were rare in series A and B deals.

Mr. Van Der Velden says partnering with large pharmaceutical companies gives venture capitalists access to expertise and insight. "We can reach out to the heads of their business development teams, we can reach out to the heads of their therapeutic teams, and our CEOs can reach out to those people if they want to."

Partnering with venture capital firms allows pharmaceutical companies such as Eli Lilly to mitigate risk and expand the number of potential drugs they can consider, Ms. Sullivan says.

Lumira Capital, which has a continuing partnership with Merck & Co., does syndication deals with other pharmaceutical firms. Mr. Van Der Velden says his company recently closed a deal that had three different pharmaceutical companies as strategic investors.

Investors are usually looking to a trade sale to a large pharmaceutical company as the end-game on these deals, Mr. Van Der Velden adds. In some deals, a pharmaceutical company may have special rights, such as first refusal on a sale, while in others, like Mr. Van Der Velden's deal with three partners, no one has any special rights.

Ms. Sullivan says that even though such deals could put new products in the hands of competitors, "creating that innovative ecosystem will benefit the companies and the patients."

"Going forward (pharmaceutical companies) are going to be playing a growing role," says Nitin Kaushal, managing director of corporate finance at PricewaterhouseCoopers.

According to PwC's Canadian Life Science Industry Forecast for 2013, 79 per cent of the mostly small companies in the life sciences sector are looking to partner with large pharmaceutical companies for funding, an increase from 30 per cent in 2007.

More than 80 per cent of Canadian life sciences companies have under 100 employees, according to the report. The vast majority are strictly research and development focused, and they are looking to license their products, or to be acquired by a larger company. Mr. Kaushal says pharmaceutical companies are increasingly taking the place of institutional investors, such as labour-sponsored funds, in the life-sciences industry after they lost interest over the past 10 years from a lack of success stories.

Mr. Kaushal points out that there have been a large number of major failures in stage three testing – the final step before a product is released commercially. He says this is a sign of how "complicated the science is to get it to market."

But Mr. Van Der Velden, who is also the president of the Canadian Venture Capital and Private Equity Association (CVCA), says the idea that "the life-science part of the world is harder to make a buck at" has more to do with perception than returns. "That's just fundamentally untrue," he says. "The reality is that life-science investing has done better than almost any other asset class in the venture ecosystem."

Mr. Van Der Velden says that while the general public is very familiar with many venture-backed IT companies, they're less familiar with companies such as Pharmasset, which Lumira Capital invested in, and that sold for $11 billion in 2011. "Our big wins don't have the same kind of resonance," Mr. Van Der Velden explains.

"In the last five years it's been very tough" to raise funds, "especially for biotech and pharma startups," says Sonia Sanhueza, life sciences practice lead at Toronto's MaRS Discovery District, which is home to 270 life-sciences startups.

She says small companies in the sector are seeing less interest from angel investors and government grants that only provide matching funds. With the need for extensive research and testing, large amounts of capital are needed to bring a product to market.

She also sees growing potential for "earlier stage partnerships" between startups and large companies.

"You can only do so many things in-house, you can have only so much expertise in-house," Mr Van Der Velden says. "A lot of fundamental innovation has proven itself not to come out of big pharma."

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