After a banner year in 2012, the number of FDA Drug approvals dropped back to 27 for 2013, a number more in line with the average rate of approvals for the last few years. As many observers have commented, the cost of developing a new drug has skyrocketed (see, for example, this analysis by Matt Herper).

However, I wonder if there isn’t a more fundamental limit on the sustainability of the drug industry in aggregate: By many estimates, the time it takes to develop a new small molecule drug has become longer than the length of market exclusivity. According to data from the Pharmaceutical Benchmarking Forum, it takes 12.5 to 13.5 years from initial screening to final drug approval (as reported on this web site; other sources give similar numbers). Even assuming a new molecule isn’t patented until 2-3 years after the project begins, that leaves 10 years or fewer on the market.

Think about the implications of this fact. A pharmaceutical firm generates high gross margin cash flow (the kind of money needed to fund extensive R&D) for only as long as its products have market exclusivity.* This means that for a pharmaceutical company’s business to be sustainable, in aggregate the firm must develop a new product within the length of time it generates cash from an existing product. But how can the firm do that, if on average it takes longer to develop a new product than an existing product is on the market? It can’t. No matter how many projects are conducted simultaneously, no matter what the overall success rates, at steady state you have to develop a new product in less time than the amount of time you have it available for sale. Otherwise, revenues will decline as a company struggles to replace lost products — behavior strikingly like what we’re seeing today for quite a few firms.**

Clearly, I’ve simplified the story somewhat; there are other ways of financing product development besides free cash flow — loans, venture capital, co-investing, buying assets from other firms, etc. Of course, some individual firms may fill their pipelines faster than they lose products — whether due to better management or just plain good luck. But as a system, I don’t see a way around this fundamental limit of having to replace products faster than they disappear.***

I’d love to hear comments from readers.

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* Being much harder to copy (at least under current law), biologics are a different story. Market exclusivity can be maintained for a longer period.

** Note that in comparison to existing firms, a brand new company looks like a winner, at least for a while. A new product comes on market, revenues skyrocket, stock price leaps, etc. It’s only 10 years later when a replacement fails to come along.

*** Actually, I can see a theoretical way out of this — lots of early stage R&D funded by very patient investors (think long term venture capital), who sell their assets to pharma firms. An individual pharma firm could then accumulate new assets faster than existing products go off market. But the early investors would have to endure negative cash flow for a long time.