Eli Lilly and Co. spent $2.4 billion on life-science R&D last year, exploring everything from antisense technology to synthetic exendin-4. But the biggest experiment under way at the company isn't taking place in a lab or a clinic. And the results of that experiment - highly promising so far - have implications not just for Lilly's ability to keep developing and selling new medicines, but also, perhaps, for the way that companies in other industries might want to set their strategies.

The question Lilly is investigating has engaged every pharma company in recent years: how to steer the business as the industry continues its transition from an era of strong growth, rich profits and highly productive research into - well, into what isn't really clear. What is apparent is that the industry as a whole isn't likely to introduce enough new, broadly marketable drugs to keep all its participants growing healthily. There are various schools of thought on what individual companies should do about this, with the most familiar being the one endorsing major mergers. Such deals enable big companies to cut costs while adding large chunks of research capability (stressed in the early-1990s deals) or products and marketing clout (more important in recent transactions). Market leader Pfizer Inc., with $45 billion in revenue and two major acquisitions in the past five years, is, of course, the most prominent example of the megamerger approach. No. 3 Sanofi-Synthélabo SA-Aventis SA ($30 billion when the deal combining the two companies closes this summer) is the most recent.

Meanwhile, medium-size Lilly ($12.6 billion in revenue) is testing a different hypothesis: that the way to battle the giants is to selectively add capabilities and assets, mainly through a system of carefully managed alliances. "A cornerstone of our strategy is partnerships, and creating value through partnerships," says David Thompson, Lilly's vice president for corporate strategy and business development. Says John Lechleiter, Lilly's executive vice president for pharmaceutical operations and Thompson's boss: "You can create virtual size through these partnerships."

OK; partnering isn't unusual. Pharmas have a long history of collaborations - with each other, with academia and especially with the teeming ranks of biotechnology companies. In fact, over the past decade or so, as their own labs have often struggled to convert a flood of new science and technology into products, the pharmas have made more and more deals with young, narrowly focused biotechs. And no wonder: Backed by waves of venture capital, the public markets and those partnership deals, biotechs originated more than 40% of drugs now in clinical trials. Pharmas (and the bigger biotechs) now must compete with each other for access to the most promising projects. Even proud Merck & Co. - like Lilly a skeptic on the value of megamergers - is partnering more, easing a reliance on its storied (but lately stymied) labs. The top 20 pharma companies formed 130 partnerships with biotech companies last year, up from 89 in 1993, Windhover Information Inc. reports.

So what makes Lilly special? Well, for starters Lilly is one of only a few exceptions to the general falloff in productivity. Its pipeline may be the industry's fullest, and its commercial operation is making innovative moves to distribute multiple new medicines. With recent launches like Cialis (now second to Pfizer's Viagra in the multibillion-dollar erectile dysfunction market) and imminent ones such as Cymbalta (a major new antidepressant), Lilly is poised to add seven major products in a period of about only two years. Partnerships don't deserve all the credit, but they're a major part of the equation - as witness the Cialis joint venture with Seattle biotech Icos Corp. and the pact to commercialize Cymbalta outside the U.S. with the German pharma Boehringer Ingelheim GmbH.

Those alliances, moreover, showcase a partnering process that is not only the industry's most developed, but also at the center of an increasingly integrated set of strategic tools Lilly has assembled in recent years. Acquisitions - such as Lilly's purchase of Applied Molecular Evolution Inc. for $400 million last November - are part of the kit. So is venture capital; Lilly Ventures launched its third fund (the $50 million Lilly MedTech Venture Fund) in January. It's too early to declare Lilly's approach to the business a distinct model or an unqualified success; for one thing, the company faces what Lehman Brothers Inc. analyst Tony Butler calls "execution risk" as it tries to launch all those products. And Lilly only recently overcame some serious manufacturing problems, bane of many a drug company. But it's not too soon to study the impressive array of dealmaking and relationship-management machinery Lilly has assembled as it tries to set the pace in a world where innovation is far-flung, markets are global and no company can do everything itself.

It is Thompson, a 57-year-old Michigan State M.B.A. and one of the industry's best-known dealmakers, who is responsible for this apparatus. Reporting to Lechleiter and working partly through the dotted-line relationships so familiar to corporate development and strategy leaders, Thompson has a range of duties matched by few if any of his peers at other companies. He leads an organization of 75 professionals, all based on the eighth floor of Lilly's Indianapolis headquarters. And he's responsible for corporate strategy; the dealmaking and post-deal components of partnering; a vigorous out-licensing operation; acquisitions; and the three venture capital funds. "Different folks have different combinations of that," says Thompson. "Not very many have them all. And for us, that was a straightforward, concerted decision on how we wanted to approach the problem."

The partnering skills are at the heart of Lilly's approach. Though nearly every pharma now waves a "partner of choice" banner, Lilly stands out for having worked long and hard to deliver on the slogan. In the 2004 Global Pharmaceutical & Biotech Partnering Survey conducted by IBM Business Consulting Services, biotech companies ranked Lilly as the best overall partner. Lechleiter says he's seen a "meteoric improvement" in the way Lilly manages partnerships over the past five to seven years. The key to this improvement? "Approaching partnering as something that could be understood as a process, and therefore improved upon," says Lechleiter, 50, who has a Harvard Ph.D. in organic chemistry and rose through the ranks in Lilly's research operation.

The work has spanned the whole partnering process, from identifying potential allies to due diligence and deal structuring to post-deal management. (In Lilly shorthand, "find it," "get it," and "create value." See chart.) But the most important innovation came in the post-deal realm, with the creation in 1999 of Lilly's Office of Alliance Management. Says Thompson: "When you look at those three and ask which is going to be the hardest to duplicate, it's the alliance management."

The OAM supports about 100 collaborations, devoting more resources to the big ones, such as the deals with Icos and Boehringer. Senior executives, starting with Lilly chairman Sidney Taurel, champion its work internally and externally and help give it the stature it needs to play its unique role. The OAM doesn't initiate an alliance, or negotiate it or direct its work. Instead, the office focuses on the relationship - the key, Lilly believes, to improving upon the industry's chronically low success rate. "If 50% of collaborations fail, it's not that they're failing for technical reasons," says Patricia Martin, executive director of the OAM. "It's a matter of governance, of leadership."

How Martin and her 15-member team accomplish their mission is worth a closer look. What's immediately striking, though, is how much of their work involves commonsense measures - attention to communication, the capture and re-application of lessons learned. "Nothing we do is rocket science," says Martin, 43, a Harvard M.B.A.

Yet the commitment to alliance management does represent an ambitious trajectory -- the path that Lilly hopes to follow through the global swirl of science, regulation and finance that characterizes the industry. There are some big, unsettled issues out there. Are large research operations really inherently less productive than small ones? "It's not clear," says Kenneth Kaitin, director of the Tufts Center for the Study of Drug Development in Boston. "In the mid-1990s, there were a lot of [FDA] approvals. What typically happens is that after a big jump, there's a lag - the industry is retooling." Do those who see the industry stratifying into two tiers - giant generalists, such as Pfizer, and smaller specialists, such as Roche - have it right? "There will be only a handful of companies that are really in the primary care medicine business," says Ed Saltzman, president of Milburn, N.J., consulting firm Defined Health. "It's an overwhelming change." Lilly is a hybrid, competing in primary care with drugs such as Cialis while also investing in oncology, cardiology and other specialist areas. Will it have to choose?

Pharma strategists have been plotting their courses through this turbulence for some time. In 1993, their chief worries were the rise of managed care and pressure from Wall Street to do something about an imminent dearth of new products (something of a false alarm, as it turned out). Not coincidentally, that was also the year that Lilly, a company founded in 1876, with deep local roots and a reputation for insularity, got a management shakeup. A sinking share price and a lack of strategic clarity prompted the board to oust CEO Vaughn Bryson, a career Lilly man, after just 20 months at the helm. The move - similar to contemporaneous leadership changes at IBM Corp. and General Motors Corp. - came as a shock to employees.

The new CEO was Randall Tobias, who in his previous role as a vice chairman at AT&T Corp. had learned something about industries in transition. A Lilly board member prior to becoming CEO, he is also a prominent Hoosier, and he proved able to work effectively with established Lilly leaders such as Taurel (who became his chief operating officer) and Gus Watanabe, who retired last year as executive vice president for science and technology. In 1999, after splitting off Lilly's medical devices business (today's Guidant Corp.) and refocusing the company on some key therapeutic areas, Tobias stepped down. Taurel, a Lilly operating veteran who grew up in Morocco and Spain, took charge of a less bureaucratic, more open and more international company. He is the first Lilly leader not from Indiana. (Indeed, up until 1977 the company still had an Eli Lilly - a grandson of founder Colonel Eli Lilly - as honorary chairman.)

To the concern of many Hoosiers, Lilly has more than once been the subject of merger speculation. Tobias came in partly to ward off a possible takeover, and the chatter started up again in 2002 as manufacturing problems flared and Lilly's patent on its phenomenally successful Prozac was expiring. The fact that a 14% block of company stock is held by the Lilly Endowment Inc. no doubt makes it easier for Lilly's leaders just to say no when the idea of a merger comes up. But so, perhaps, does a plain-speaking confidence in Lilly's way of doing things that seems woven into the company culture. It's an attitude that comes through when Thompson, sitting on a panel at an industry conference, jokingly complains that a big-picture type question he's been asked is too long. Or when Lechleiter (who is a good bet to succeed Taurel as CEO) is asked what he thinks of the boom in alliance programs and consulting. "You can hire one of these consulting firms to come in and borrow your watch and tell you what time it is," says Lechleiter, a Kentucky native who did his undergraduate work at Xavier University in Cincinnati. "But I think we've learned more from our own experience."

Nobody has had a bigger hand in building Lilly's body of experience than Thompson, who has been involved in dealmaking for much of his career. After four years as vice president of pharmaceutical product management and licensing, he became vice president of corporate business development in 1992; in 2001, he added responsibility for corporate strategy.

Thompson recalls that in the 1980s through the middle 1990s, Lilly did mainly early discovery deals. The idea of making partnering a cornerstone of the strategy had its origins in a study Lilly conducted in 1996 and has since repeated three times. "We did a project to look at how important size is in our business, and how do you want to compete," he says. "A lot of people in the industry were saying that size is very important. Still are. But we concluded that this is not a scale business. It's a critical mass business."

Lilly reasoned that what it needed was not greater scale, but greater access to the world of innovation unfolding in the industry. Partnering, not a major merger, was the way to get that. Which prompted a board member (so the story goes) to ask a simple question. If partnering is so important, what are we doing to get better at it? A 1997 exercise yielded the "find it, get it, create value" framework, and the company then set about organizing teams to accomplish each function. All of them continue to be refined.

The find-it group came first. The challenge here is to track the great mass of life-science research going on at thousands of companies and universities around the world. "I don't envy large companies having to sort through it all," says Stanley Crooke, chairman of one of Lilly's biotech partners, Isis Pharmaceuticals Inc., and before that president of R&D for SmithKline Beckman. The 15 to 20 people who work in research acquisition are part of Lilly Research Labs, with a dotted-line relationship to Thompson. They're organized by therapeutic area (oncology, say, or central nervous system), with a separate group looking out for enabling technology, useful in multiple areas.

So far, so good. But as Thompson explained to the board last fall, Lilly wants more from the find-it folks: specifically, more vigorous outreach (as opposed to desk research) and tighter connections with the people who must make use of the research they bring in. The positions are now being filled with higher-level people, who are on a path to senior management jobs - and are chosen by the therapeutic chiefs themselves. "Their single job is to find external innovation, wherever it may be," says Thompson.

Next came the get-it guys - the dealmakers who negotiate and structure agreements. The deals, of course, can take many forms, from the joint venture arrangement with Icos (insisted upon by George Rathmann, then chairman of Icos and before that, of Amgen Inc.) to an equity-stake-plus-milestone-payment deal like the one Isis signed in 2001, to a milestone-and-royalty deal like the one with Japan's Sankyo Co. Ltd., Lilly's partner on a late-stage antithrombotic candidate. The transaction team was already well established in 1997; what was lacking was a consistency in due diligence. Today, Thompson counts diligence as a strength. "We do it fast, we do it thoroughly, and we don't waste the other party's time," he says.

When the Office of Alliance Management - the "create value" component - was launched in 1999, it was initially part of Lilly Research Labs. Not long afterwards, though, the OAM was moved into Thompson's organization, which makes for easier coordination with the corporate development people who negotiate deals. "We're there at due diligence, if not before," Martin says. "We're not negotiating, but we want to know what was said." The arrangement also reflects the range of Lilly's current collaborations, which are pretty evenly divided among enabling technologies, early-stage research, development-stage deals and commercial transactions. All are managed by the OAM, a contrast with the setup at most other companies, where early-stage deals and commercial deals may be handled at opposite ends of the organization.

The OAM is evolving, too. After three years as director, Martin is moving to a new job as executive director of osteoporosis products. Her successor (unnamed at press time) may see the office expanding its current mandate, which is to handle anything involving intellectual property. Lilly already has manufacturing alliance managers who use OAM tools and follow a dotted line into Martin, and she believes the tools are equally applicable in other realms, such as sourcing.

In January 2001, Lilly took another step to help it tap into innovation originating elsewhere, launching its first venture capital fund. This is the $50 million e.Lilly Venture Fund, which invests in startups (half a dozen so far) promising a "transformational impact" on Lilly's business model. Later that year came the $75 million Lilly BioVenture Fund (eight investments to date, in biotechs pursuing novel enabling technologies or therapeutic projects), and just this year came the Lilly MedTech Venture Fund (devices and diagnostics).

A familiar practice at some pharmas (Johnson & Johnson and GlaxoSmithKline plc have well-established programs), venture investing is shaping up as an important one for Lilly. Dominick Colangelo, the 40-year-old managing director of Lilly Ventures, explains that the company likes to take board seats and to facilitate interactions between portfolio companies and the rest of Lilly. "We are financial investors in areas of strategic interest," says Colangelo.

Looking at Lilly Ventures' holdings is a good way to get a bead on what may lie ahead in healthcare, on both the therapeutic and commercial fronts. Cambridge, Mass.-based Hydra Biosciences Inc., a Lilly Bioventures investment, is working in the futuristic field of regeneration biology, hoping to create drugs that will reprogram a patient's own cells to restore damaged tissue. One of the e.Lilly fund's holdings is RelayHealth Corp., an Emeryville, Calif., startup working to move healthcare communications - including some doctor-patient interactions - online.

Is venture capital the last piece of the puzzle for Lilly? That's unlikely. In a business where most product ideas fail - and successful products take 10 years and cost $800 million - the organization Thompson runs has to be considered a fairly new one. One trend to watch is a shift of emphasis toward strategic acquisitions, driven in part by the rising prices biotech companies can command in partnership deals. "We haven't made a lot of acquisitions," says Thompson, "but we think we're going to be making more. Acquisitions may actually bring you more capabilities and assets in a single transaction than a series of partnerships."

The leading indicator here is Applied Molecular Evolution. Lilly was already partnering with the San Diego-based company, getting help with its large-molecule discovery efforts. AME, for its part, had reached a point where it was either going to do further financing or consider being acquired. Tom Bumol, Lilly's vice president of biotech discovery research, championed the the acquisition.

Thompson's M&A team negotiated the transaction, and once it had won approval from Lilly's policy committee (the top eight people in the company, including chief financial officer Charles Golden and Steven Marc Paul, executive vice president for science and technology), they closed it. And then the alliance manager who had previously worked with AME had a new assignment: Join the post-merger integration team assigned to the deal, and help build up expertise for use in future acquisitions. AME will be a subsidiary and remain in San Diego, center of a lot of biotech activity. "It's a hub and a first-class organization around which we may expand," says Thompson.

Even as Lilly adds scientific talent and capabilities at the beginning of the drug creation process, it has to keep thinking about how the finished products will reach patients in years to come. "I think it's going to be the commercial end of the business that will change the most in the next 10 years," says Lechleiter. Here, too, Thompson's team can help. A commercialization partnership with Quintiles Transnational Corp. will help Lilly launch Cymbalta in the U.S. on a scale closer to the one that Pfizer, with its much bigger sales force, might manage. The RelayHealth investment, while still a long shot, could be a window on a world where new distribution channels come to the fore.

Of course, as scientific, demographic and regulatory developments unfold, the economics of the pharma business could change in ways that hardly anybody now anticipates. If Lilly's prescription for growth and the organization supporting it were a drug in development, you probably wouldn't say it was ready for approval. The signs are good, though. - Kenneth Klee

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