Big pharmaceutical houses have long relied on drugs developed by others—particularly biotechnology firms—to fill the huge gaps in their product pipelines. In-licensed drugs accounted for 30 percent of Big Pharma's revenues in 2001, and with the looming expiration of many key patents, to say nothing of lagging R&D productivity, that reliance is likely to increase. But this licensing strategy, our analysis shows, has a widely overlooked flaw: deals are often struck too late to generate maximum value.

To put it simply, pharmaceutical companies are overdiscounting for the uncertain prospects of deals made early in the development process. To reduce the risk of licensing a drug that ultimately fails to win approval from the US Food and Drug Administration (FDA), these companies make low offers to biotechnology firms during preclinical testing, when researchers complete the synthesis, purification, and animal tests of a drug. About one-third of all licensing deals occur at this stage.¹ For the rest of them, pharma companies often don't commit substantial resources until clinical trials demonstrate the drug's safety and efficacy in humans. While this delay is understandable, it can cost companies tens of millions of dollars in higher fees and royalty payments to the biotechs...