Strategic alliances, with care and creativity.

Many businesspeople consider Merck the master of the strategic alliance. What are the company's secrets for setting up profitable alliances?

At Merck, we make almost every decision within a strategic setting. Because our business is ethical pharmaceuticals, or drugs you purchase with a prescription, and thus driven by research, we constantly examine whether the world will continue to economically reward new drug discoveries. Then we factor in the very high risk of creating and developing these new drugs. After all, when we create a new product, we're undertaking a long-term project. The process generally takes 10 to 12 years, and the costs average about $230 million for each product.

Each time we've raised that question, we've concluded that we will be properly rewarded for novel new drug discoveries. These are the kinds of new products that not only help the country through innovation, employment and investment, but keep people gainfully employed and out of high-cost health care alternatives. So we're comfortable staying focused on ethical pharmaceuticals--and we accept the high level of research that entails, on which Merck spends more than a billion dollars each year.

But we realize we need continuing access to new technologies to stay competitive in the pharmaceutical industry. I think having access to new technologies, and to new partners by setting up strategic alliances, is a cost-effective way to do that.

What made us first consider strategic alliances? In the 1980s, we watched a "merger mania" going through our industry. First, mann-La Roche pursued Sterling Drug, then Eastman Kodak acquired Sterling, Bristol-Myers acquired Squibb, Beecham merged with SmithKline and eventually Roche gained control of Genentech. Then, of course, the Japanese purchased several smaller firms, and the French company, Rhone-Poulenc, gained control of Rorer.

Each one of these mergers required the buying companies to pay a premium, well above the acquired company's market value. In essence, these companies were paying the eventual synergies of the combination to the selling shareholders. It appeared they were putting themselves behind from the start. That seemed too expensive for us. We want to bring down the costs and minimize the risks of our external growth program, so we decided on strategic alliances.

MERCK'S PARTNERS

Before we entered into our first alliances, we identified Merck's primary strategic needs, which were to gain access to: 1) more research, 2) more products and 3) more global presence. That helped us target the most appropriate partners.

For instance, in 1982, we entered into a collaboration with a very successful Swedish company, AB Astra. Essentially, Astra licensed its current and future products to us for marketing in the United States, due primarily to our expertise in the regulatory approval process and in marketing in this country. The initial agreement is for Merck to develop and market the products through a royalty-bearing license. However, the agreement provides that, when we reach a certain sales level by year-end 1993, we'll form a joint venture by 1995, at which time all the products that come to the United States from Astra Sweden's research will be owned 50/50 by Merck and Astra.

As for our ethical pharmaceuticals, we know that one way we can extend a product's life cycle is to move it into the over-the-counter market. We had several products we thought were eligible for that kind of move, but we had no expertise in marketing over-the-counter drugs. So we approached Johnson & Johnson and ultimately set up an alliance called Johnson & Johnson-Merck Consumer Pharmaceuticals Co.

Johnson & Johnson-Merck Consumer Pharmaceuticals Co. will be a global, stand-alone venture when we reach a certain sales level. We anticipate our first product from the alliance in the mid-1990s. In the meantime, we've used the financial resources of both partners to purchase Mylanta from ICI, an asset we used to jump start the joint venture, while we wait for initial products to be "switched" from prescription to over-the-counter availability.

While we were pursuing more research, we identified Du Pont's pharmaceutical research capabilities. At the time, Du Pont had a $200-million pharmaceutical division in a then $35-billion company. One of the division's new products was about to move from basic to developmental research and hopefully then move to market. But, while Du Pont had terrific basic researchers, the company hadn't built up regulatory, development or global marketing expertise.

So Du Pont and Merck started out by co-developing that product. We then suggested to Du Pont to consider a global joint venture with us. Du Pont agreed, and that's how Du Pont Merck began. In allying with Du Pont, we essentially increased our research people by one-third. Merck then had 4,500 researchers, and Du Pont had 1,500, so we now had access to 1,500 more researchers overnight, which is a major accomplishment.

Finally, our most recent alliance is with Connaught Laboratories, with which we're co-developing and co-marketing vaccines in the United States. While Connaught is located in the United States, the firm is owned by Institut Merieux, a French vaccine company. That's attractive to Merck because it helps meet our strategic need of more international business. We're close to concluding a joint venture for vaccines with Institut Merieux in Europe. Our long-term goal is to be a global leader in research, manufacturing and marketing of vaccine products in partnership with Institut Merieux.

THE STRATEGY IN AN ALLIANCE

Many things can make a strategic alliance work or fail. At Merck, we've found we should concentrate on the following areas to help ensure success.

* Above all, choose the right partner, one in which you have confidence and with which you have a strategic fit.

How do you decide which companies to pursue for strategic alliances? First, determine your strategic needs and the objectives of the venture. In Merck's case, for instance, when we decided we needed expertise in over-the-counter pharmaceuticals, we asked ourselves, who's the best company in over-the-counter pharmaceuticals? We chose Johnson & Johnson. Likewise, we admired both Astra and Du Pont for their research and scientists and for their productivity. And we were interested in Merieux/Connaught because that company is international, research driven and one of the leaders in the field of vaccines.

Another area we look at in choosing a partner is the quality of the potential partner's scientists and the company's contribution to science. A successful track record of discovering and developing innovative products is one important reason why we paired with both Du Pont and Astra.

* Make sure you and your partner have a common goal.

* Insist on good communications at the highest levels. The CEOs of each company must have a common vision, and they must be committed to the alliance to make the venture work.

* Have patience in structuring the deal, because it takes time to think through every detail and to make sure each company feels it's being treated fairly. Compared to making an acquisition, which may take only a couple of months, setting up an alliance generally takes a year or more. Much of this time is well spent since it results in learning to deal with each other.

We try to structure our ventures as 50/50 partnerships, not only in terms of the contributions from each party but, as important, in terms of management. That way, we're sure we really have a commonality of interest and no one party dominates.

How do we do that? First, we create an equally represented board of directors for each venture. This board is made up of three or four executives from each company who are responsible for strategic operations of the venture.

Second, we try to make equal contributions. That's sometimes difficult when you're evaluating expertise. In the Astra and Du Pont alliances, for instance, Merck brought to the venture regulatory, development and marketing expertise. Thus, we had to calculate a value for those contributions and then persuade the other party that those values were reasonable. Conversely, when we established an alliance with Johnson & Johnson, they brought the sales and marketing expertise, so we had to agree on the value of that. In every case, the company that isn't contributing expertise has to match the value of the other firm's expertise with either products or cash.

BE YOUR MOST CREATIVE

While strategic alliances can be profitable, they also offer some challenges. They inherently limit your upside potential, because you're in a partnership. They're more difficult to manage. And they demand creativity in the deal structure. But overall we at Merck believe they will add value and be consistent with our objectives. In short, we're convinced our joint ventures and alliances will enhance shareholder value.

To make the alliances work, we created what we call a "fairness and balance concept." It combats the thinking that you should always try to win at the negotiating table. In a strategic alliance, if you "win" in negotiations at the expense of your alliance partner, you defeat the longer-term purpose for the venture.

Under this concept, we let the marketplace eventually determine how much the contributions are worth, based on the economic forecasts, and then adjust to the market performance in five or 10 years.

Take, for example, our alliance with Du Pont. In the two years we've been part of this alliance, the venture has been doing much better than we initially forecasted. And most of the better performance is coming from products that Du Pont contributed, so early on Du Pont is benefiting from the alliance. But we're pleased because we're setting a new sales trend line for the future. And we are also being fair.

Another very important issue in a stand-alone venture is compensation. Structuring a pay-for-performance incentive system around an alliance, to have everybody pulling for the same objectives, is difficult. Why? Because, for one, ventures don't have incentives such as stock options to offer since they're not public companies.

Again, you have to be creative. So the day we opened the door on Du Pont Merck and 3,800 people came into the new company, we gave each a certificate of stock that we called "founder's stock." Essentially, this certificate gave each employee ownership in the future profits of the company if the alliance achieved certain goals. It was very well received. The employees immediately felt they were part of the whole company and they had a direct role in, and will benefit from, the success of the company.

By being creative, we've also been able to use our alliances to help us win "auctions" to add other assets. For instance, we purchased Mylanta from ICI in England by including a Merck pharmaceutical product in the deal.

THE MAGIC VENTURE MENTALITY 

But none of these approaches to strategic alliances will work if you don't have what I call a "venture mentality." Much of this involves our venture board of directors and operating committees. And, I might add that, although we try to cover as much as possible at our negotiations, circumstances do change and we have to be flexible. We have to be willing to renegotiate--and do it in the spirit of our strategic visions. This, I believe, is an essential part of venture mentality.

Look at it this way: Now you have a partner. You sit down at a table with equal representation, and you have to work out problems together. It's a different style of management, and you may need a different type of manager.

Today, empowerment of employees is a key managerial trend, and that's exactly what you need to achieve in a strategic alliance. You cannot enter an alliance thinking how you're going to gain at the expense of the other party or terminate the agreement. Instead, you should be trying to figure out how to sustain a successful operation to achieve both partners' strategic objectives.

Here's an example. In ethical pharmaceuticals, Johnson & Johnson is a direct competitor of Merck. Johnson & Johnson also owns 100 percent of an over-the-counter business led by Tylenol. So, sure, Johnson & Johnson is a competitor, but its expertise is the very reason we joined the company in a venture. Similarly, Merck is a competitor of Astra Merck and of Du Pont Merck. In each case, however, we have built in the proper incentives to commit each company to the success of the venture.

There is a delicate balance, but that's part of maintaining the venture mentality. You have to always be aware of each partner's objectives and work to achieve that delicate balance. You can't play the game any other way and be successful.

THE PEOPLE BEHIND THE ALLIANCE

Each CEO plays a key role. Also, many other people are involved in the planning and start-up of a strategic alliance, and each is very important to the success of the project.

For instance, at Merck, the typical decision-making team is made up of the top eight senior officers of the company who meet on all strategic, tactical and operating matters. They form what we call an operating review committee. As part of their duties, they act as the clearinghouse for proposals to set up strategic alliances and then, if they agree with the proposal, they forward it to Merck's board of directors.

By the way, we're extremely proud of the fact that all of our ventures were created and implemented solely with Merck personnel, without external resources. Internally, this has been accomplished with several people from our corporate development staff and from our finance and legal sections. We call this team our external growth group ("EGG"), and the members convene when necessary to act as investment bankers and outside lawyers for these kinds of deals.

Once the proposal for an alliance is approved, it's important for the executives involved to take time out from their day-to-day responsibilities to participate in the alliance's development and management to make it successful. At Merck, I'll join a financial person and a marketer or a researcher on the board of an alliance. We each bring our own disciplines to the party, and we're each there to advise rather than to hand out orders.

All in all, I find I spend about 30 to 40 percent of my time creating and developing and then managing Merck's strategic alliances.

FOR SURVIVAL

If you're a financial executive who's considering forming a strategic alliance with another firm, I suggest you first have a vision of what you want to accomplish.

Then select the right partner, develop the fairness and balance provisions I mentioned earlier and be sure to create performance measurements and incentive programs.

And, while you're setting up your strategic alliance, remember that you often get side benefits from these ventures. You build up an element of trust and mutual respect with your partners, so it's sometimes possible to collaborate in other businesses with a strategic ally.

Are strategic alliances the way to do business in the future? I think so. The companies that can master and manage strategic alliances on a global scale--and develop a venture mentality--are going to be the most successful. If you can do that, you'll have a competitive advantage without suffering all the disruption and expense that go along with acquiring assets directly.

Mr. Spiegel is executive vice president of Merck & Co., Inc., and is responsible for Merck's external growth program.