In January, Constellation Pharmaceuticals, a Cambridge, Mass.-based biotech startup in search of novel cancer therapies, announced that it was forming a partnership with Roche Holding AG's Genentech Inc. The market took little notice; it was not a deal that carried a huge price tag -- up-front payments weren't even specified. But the deal was significant for other reasons.

Constellation, formed in 2008, specializes in epigenetics, a new field of drug discovery that focuses on the molecular changes in cells that activate and deactivate genes without altering DNA. Constellation initially aims to focus on cancer treatments, which are Roche's specialty, as the drugmaker boasts a bigger oncology franchise than any other pharmaceutical entity in the world. The idea of using epigenetics to unearth new cancer treatments brought Roche to Constellation.

The pact leaves the potential for either a marriage or an escape, depending on how things go. Specifically, Genentech agreed to give Constellation $95 million in funding over a three-year collaboration period. Constellation retained exclusive development and commercialization rights to the programs developed through the partnership and would also get milestone payments and double-digit royalties on sales of the products created. It also got the independence to maintain its strategic direction and rights to the programs that aren't part of the collaboration. The partnership also gives Genentech the inside track toward an acquisition through an exclusive future option to acquire all of the company's shares on prenegotiated terms -- a buyout that would include the compounds created inside and outside of the partnership. The price includes an unspecified initial acquisition payment plus payments for contingent value rights that are based on the success of the products created through the partnership.

All told, Constellation gets to act like an independent company while getting financial security and Genentech's help on development. Genentech, meanwhile, gets access to Constellation's drug discovery technology and the potential to either buy in or cut ties based on the outcome of the partnership. And Constellation's venture capital investors -- Third Rock Ventures LLC, Column Group, Venrock, Altitude Life Science Ventures and SR One Ltd. -- already have a potential exit mapped out.

The Constellation-Genentech tie-up is just one example of new, creative collaborations and financing agreements in life sciences that represent the latest steps toward an overhaul of the biotech-VC funding model and toward fixing an R&D blueprint that has become increasingly inefficient. Deals like this one don't provide the immediate returns that investors drool over, but they are every bit as important: They are the evolution of the relationships among the pharmaceutical world's entrepreneurs, financiers and marketers.

Nearly every large pharmaceutical company has a venture financing arm, and all are using them in increasingly creative ways. Some are using them to join with other venture funds to create biotechs, as Sanofi SA has to form an entity named Warp Drive Bio LLC; others, such as GlaxoSmithKline plc and Johnson & Johnson, are pouring money into funds that invest in various life sciences companies. Funding consortia are springing up backed by governments in Russia, England and Canada, among other countries. And drug programs previously left for dead are now being offered up to federally funded researchers with financial incentives.

"We are in the process of a restructuring -- and hopefully the awakening -- of the biotech ecosystem," says Alexis Borisy, CEO of Warp Drive in Cambridge and a partner at Boston-based Third Rock Ventures, which fostered the development of Constellation. "What people are trying to figure out is, how do we structure [a deal] so it plays to each party's key strengths?"

The need for such a massive shift in thinking comes from issues facing every member of the drug development pipeline. For Big Pharma, the problem is a matter of desperation and cost. The world's biggest drug companies typically spend roughly $9 billion per year on research and development, while the cost to actually develop a drug and bring it to market has become more and more expensive, given the fact that the chemical-based drugs of the past, which are cheaper to produce, are increasingly being replaced by protein-based biologic drugs. Abbott Laboratories' Humira, a biologic drug, is set to eclipse Pfizer Inc.'s Lipitor, a chemical-based compound, as the world's top seller.

Unfortunately for many pharmaceutical companies, pipelines are thinning at the same time patent cliffs have arrived. Lipitor lost patent protection in November, just a month after Eli Lilly and Co.'s antipsychotic cash cow Zyprexa suffered the same fate. AstraZeneca plc's blockbuster depression drug Seroquel and Bristol-Myers Squibb Co. and Sanofi's Plavix followed in the spring. Combined, the four drugs totaled about $30 billion in worldwide sales in 2011. And more patent expiries are on the way, all with blockbuster drugs harder and harder to come by.

With such massive revenue losses looming, drug companies have been trying a variety of strategies to build up their pipelines, including M&A. But in doing so, pharmas created a seller's market for biotechs containing promising mid- to late-stage assets. Bristol-Myers paid a 166% premium to buy Inhibitex Inc., largely because of one drug, a nucleotide inhibitor for hepatitis C in Phase 2 testing. This followed Gilead Sciences Inc. paying $11 billion -- an 89% premium -- for Pharmasset Inc. and a similar compound also in Phase 2.

"Like any other maturing industry, the low-hanging fruit is no longer there," says Dechert LLP partner Kristopher Brown, who has worked on a number of acquisition and financing transactions in the pharmaceutical space.

Private investors are now more cautious, and initial public offerings are no longer seen as a likely exit. With drug development exponentially more expensive and complex than before, the startup biotech knows it will most likely need Big Pharma's help either as a partner or a buyer, and sometimes both. And the venture capitalist knows that the traditional fund framework based on a three- to five-year exit may not work anymore to get a drug to market, Brown explains.

"It takes a ton of cash to do this," he says. "You need money and resources devoted to getting a drug across the finish line, so I think the pharmas recognized this, and you see it with [their] deciding to get into the venture game."

Enter the concept of externalization, through which pharmaceutical companies are outsourcing their R&D costs through collaborations with biotechs and other drugmakers to share the risk of drug creation. And with those tie-ups have emerged a slew of Big Pharma venture arms: Novartis Venture Funds, Pfizer Venture Investments, Lilly Ventures, Merck Research Ventures Fund and AstraZeneca's MedImmune Ventures, among others. All are armed with the financial might of their drugmaking parents, allowing Big Pharma to get in on the innovation at its earliest stage and give it the inside track to either partner with the biotech or acquire it when the target inevitably needs enough cash to complete the development of its drugs.

"They're funding the very, very early-stage R&D outside the large pharma entity," Brown explains. "They won't get the Inhibitex return, but they will end up with 3 or 4 times what they funded and then acquire [the company]."

This type of environment has become the background for a series of transactions playing out largely under the radar. Perhaps the most unique approach to date has been the agreement struck between France's Sanofi and Third Rock to create Warp Drive Bio.

Third Rock isn't a typical venture capital firm: Rather than taking stakes solely in the ideas of others, Third Rock actually creates more than half of the companies it invests in. The firm has a formalized process by which "seed projects" are created through internal discovery. Some projects gain steam, get funding and become companies, and others die.

"It's sort of a unique model in VC," Borisy says. "It's very much this process that Warp Drive Bio comes from."

Third Rock puts in a lot of time forming relationships with senior executive teams at pharmaceutical companies, which allow it to find out the type of projects that intrigue the people who could eventually acquire their seed projects. One of those is a genomics search engine that can be used to find molecules and turn them into potential drugs -- the platform that became the foundation of Warp Drive Bio.

The idea, however, was just that -- a concept that needed a leap of faith and $125 million. So Third Rock pitched it to several pharmaceutical companies before ultimately striking a deal with Sanofi. "[Sanofi said] this is really exciting; let's try to come up with a deal structure that makes things compelling to all of us," Borisy says.

The result contains three novel deal components: First, Sanofi, Third Rock and other investors poured in the $125 million in capital -- some in equity, and some not, according to Borisy -- via a Series A round done simultaneously with the founding of Warp Drive. Warp Drive will only see the full $125 million if it meets certain milestones over the next five years. Second, Sanofi and Third Rock have installed a put option through which Sanofi will have the exclusive right to buy Warp Drive at a fixed price, either "north of $1 billion" or potentially "substantially more," that is prenegotiated, depending on what value Warp Drive actually achieves, according to Borisy. And last, Sanofi, despite having the put option, does not have exclusive control over the company. Warp Drive is free to make its own decisions and establish its own partnerships with other pharmaceutical companies.

"The founders get derisked because they know money [will be there] if the breakthrough drugs can be made," Borisy says. "Sanofi gets to have the external innovation that they really want to tap, and gets to ship the research and the fixed costs into a variable cost. The money only goes into Warp Drive when things are going well and when Warp Drive reaches its end."

There is one caveat: Sanofi has a protective provision in the deal preventing Warp Drive Bio from shopping itself for a higher price. But Third Rock gets what venture capitalists ultimately crave -- a full venture return "without the liquidity risk," Borisy says.

While fostering the development of a single entity to be acquired is one strategy, it isn't the most prevalent approach. Another way pharma is gaining access to early-stage companies is by securing an observer's seat overlooking biotech innovation, much like Merck Research Ventures Fund -- a $250 million fund the Whitehouse Station, N.J.-based pharma Merck & Co. set up in 2011 to invest in biotechs -- is doing through a deal with Flagship Ventures, a Cambridge venture firm that, like Third Rock, also creates companies in-house.

Noubar Afeyan, Flagship's CEO and a managing partner of the VC fund, explains that the firm either identifies an area that currently has no approved treatment and then scours academic research hospitals for specific solutions or searches for some type of "transient technology that makes something possible but that no one has applied." Flagship will then assemble the initial IT group and build a startup through its Flagship VentureLabs unit.

Afeyan says that the firm has used this strategy to initiate more than 20 companies. Some of them, such as protein molecule developer Adnexus Therapeutics Inc., have been acquired (Bristol-Myers paid $430 million for the company in 2007), while others, such as medical-diagnostic-products company T2 Biosystems Inc. and cancer drug developer Theracrine Inc., remain private.

Merck, Afeyan says, is "interested in finding a way to get close to the innovation ecosystem, particularly in the Cambridge-Boston area."

Merck is well aware that other pharma companies have "set up their own incubators" and tried to start up their own companies with varying levels of success, he says. "They were looking for new models."

Merck didn't respond to requests for comment for this story.

Flagship has never pitched to pharmaceutical companies as potential fund investors. "It's just not what our strategy has been," Afeyan says. That changed when Merck indicated it was more interested in "collaborating on innovation" than making an investment. The two then formed a unique partnership, one based only on the sharing of ideas and knowledge.

"There are no strings attached. That's what an open innovation partnership should be all about," he says. "It's not that they get access or options to invest in or voting rights [to the companies]."

Instead, Merck became a limited partner in Flagship Ventures Fund IV LP, a $270 million fund the firm closed in January. It will act as an adviser and consultant to the various biotech startups that take shape, keeping Merck involved in Cambridge's biotech scene and giving it the chance to swoop in for a buyout if it sees something it likes.

"We're trying to say, how do we create the best companies possible? And if they end up doing something useful, then obviously Merck and everyone else can decide the right time [to buy in]," Afeyan says.

Merck and other pharmas are also buying in directly through large-scale collaborations. GSK, Johnson & Johnson and Index Ventures formed one of the most noteworthy tie-ups in March, when Index launched a roughly $200 million fund to invest in life sciences companies. GSK and J&J each poured €50 million ($62.4 million) into the fund, Index Life VI, which is Index's first fund solely dedicated to life sciences investments. The fund is based on Index's so-called asset-centric model, which prompts investments in single-product biotechs instead of diversified entities.

The partnership is unique not simply because GSK and J&J are injecting money into a VC fund that will back early-stage life sciences companies, but also since they have signed up in both active and passive roles: active, in that executives from both companies will sit on the fund's scientific advisory board, and passive, in that they won't have decision-making rights to the fund's portfolio companies. Thus, like Merck-Flagship, GSK and J&J are close to the innovation, but they will also have a financial interest riding on their bets.

"Everyone is in search of innovation, and they need to keep their pipelines going, and they need to do it in a way that can be effective over the timeline it takes to get these drugs to market, which is much longer than it used to be," Brown says.

Pharma companies aren't the only ones searching. Government agencies, and government-led investment vehicles, are also hoping to bring innovation to their countries or provide financial help to the biotechs they hope to push through development.

In 2011, the Russian government created a joint-stock company called Rusnano to develop the Russian nanotechnology industry. Fund managers reached out to the VC community and ultimately forged a novel collaboration with Prince­ton, N.J.-based VC firm Domain Associates LLC, in which the two have put a total of $760 million into a fund that will co-invest in about 20 U.S.-based healthcare technology companies and a pharmaceutical and medical-devices-­manufacturing facility to be built in Russia that will be used to produce drugs and other products. The partnership will ultimately have rights to sell the drugs in Russia, a good deal for both sides since Russia currently imports most of its pharmaceuticals.

Domain partner Brian Dovey explains that the idea for the collaboration came from discussions with people at Rusnano. "It seemed to me there could be some real synergy if we could get funding for later-stage companies and move them along the development path, and in return provide [Rusnano] with Russian rights [to the drugs] and help them build a pharmaceutical and medical-products company in Russia," he recalls.

Dovey says the theory was that the two would co-invest "side by side" in enough entities that enough products could be created to form a company.

"It would be good for us and good for Rusnano -- they'd get a return on their investment and a pharma company," Dovey says.

Other governments are also getting into creative dealmaking to bolster biotechs. The U.K., for example, has created the so-called Biomedical Catalyst, a $286 million fund operated by the country's Medical Research Council and the Technology Strategy Board. The fund will offer grants to applicants undergoing projects to solve healthcare problems.

In Quebec, which houses a majority of Canada's life sciences companies, Teralys Capital has taken part in two recent pharma-VC collaborations geared toward creating and nurturing early-stage biotechs in the province. Its lead investors are either associated with Quebec's government (Investissement Québec) or its workers and investors (Fonds de Solidarité FTQ and Caisse de Dépôt et Placement du Québec). In one deal, Merck's Canadian arm teamed with Teralys and Lumira Capital Corp. to launch the Merck Lumira Biosciences Fund. That fund, backed by a $35 million investment from the drugmaker, will invest in already-formed early-stage biotechs.

In the second, Teralys joined with Eli Lilly and others to form a roughly $150 million fund, TVM Life Science Ventures VII, that will form single-asset biotechs outright. GSK is also involved, having launched the $50 million GSK Canada Life Sciences Innovation Fund in November. GSK's fund will invest in Canadian life sciences startups and academic and health research institutions.

In perhaps the most broad government-backed partnership, the National Institutes of Health -- a division of the U.S. Department of Health and Human Services -- has called on Pfizer, AstraZeneca and Eli Lilly to help revive many of the pharma world's left-for-dead drug programs. Through the deal, the three pharma giants agreed to turn dozens of their unsuccessful compounds and related data over to federally funded researchers who are backed by $20 million in cash. The hope is that compounds previously earmarked for one therapeutic area with little success will eventually prove useful in another. NIH Director Francis S. Collins was quick to point out when the deal was announced on May 3 that azidothymidine, or AZT, was initially a failed cancer compound before it became the world's first breakthrough HIV treatment.

All of which goes to show that buried underneath the flashy world of headline-making large-scale pharmaceutical/biotech M&A, there is a fervent world of dealmaking that is every bit as significant. And as Big Pharma continues to wheel and deal, as VCs continue to adapt to a maturing market and as biotechs continue to fight for survival, that world will only expand.

"We are having a lot of experimentation and exploration in the innovation ecosystem," Borisy says. "The restructuring that is happening now is going to allow [dealmaking like] this to thrive."