Leone

Ongoing advances in technology provide medical device companies with opportunities to develop compelling new products that have substantial clinical and commercial value. New devices and technologies such as capsule endoscopy, magnetic resonance–guided ultrasound surgery, rapid DNA-based diagnostic tests, and novel materials for joint and tissue repair and replacement are transforming healthcare and improving patient outcomes. Realizing these opportunities, however, requires significant financial investments. 

In the current economic environment, both the equity and debt markets remain volatile, and a number of medical device companies are in difficult financial positions. These companies often lack the capital to pursue promising products and markets. A recent industry article highlighted the travails of three medical device companies that had stock prices below $1 for prolonged periods of time. The exchanges on which these stocks traded have issued warning letters indicating that the companies were not in compliance with exchange rules and could face delisiting.¹ In addition, the Health Care and Education Affordability Reconciliation Act of 2010 (H.R. 4872), which Congress passed in March 2010, includes a 2.3% excise tax on the sales of medical devices. This tax is scheduled to become effective in 2013, and could also increase the financial pressure on medical device companies.

Recent changes to the 510(k) clearance program and the de novo classification process used to gain FDA approval for new medical devices may also increase the cost and complexity of bringing new medical devices to market. These changes, which the CDRH 510(k) working group recommended in August 2010, would require submission of additional scientific and clinical data related to the safety and efficacy of these devices.²

The combination of increased taxes on the sales of medical devices, the potential for increased regulatory scrutiny, and concerns over reimbursement for device and therapeutic products may hurt investment in medical device companies. Several venture capitalists have already voiced concerns over investing in the medical device industry and have predicted that fewer investments will be made in the sector.³

In both favorable and difficult economic times, companies that generate revenue or receive royalty from medical device products may be able to take advantage of alternative forms of financing. Royalty monetization (RM) and revenue interest financing (RIF) each leverage future royalty or revenue streams to provide innovative companies with capital today. Both RM and RIF are forms of product-based financing that allow investors to put their money into a specific product or products rather than investing in a company’s equity.

These financing strategies have been used to fund innovation in the biotechnology and pharmaceutical industries for more than a decade. Medical device companies have also utilized these financial structures successfully, but have done so less frequently than their colleagues developing therapeutics and vaccines. This disparity is partly due to the difference in regulatory requirements between drugs and devices. The new drug application (NDA) process for approving therapeutics requires the submission of data that demonstrate “substantial evidence [of effectiveness],” typically from two or more well-controlled clinical studies.^4,5 The rigor of these studies provides investors with critical information to assess the commercial potential and risks of products in which they make RM or RIF investments. The high costs of these studies also serve as barriers to entry of competitive products.

Figure 1. Typical IP license setup.

RM or RIF investments in medical devices have historically been more limited and focused primarily on the high-risk (Class III) devices that require more costly and rigorous clinical trials under the premarket approval (PMA) process. In contrast, many lower-risk medical devices are subject to less-stringent approval requirements (510(k)s) and may be cleared even in the absence of well-controlled clinical trials. The absence of robust clinical data, combined with the relatively shorter life cycle of typical 510(k) products compared with pharmaceuticals, has made it more challenging for investors to structure long-term deals around individual 510(k) products. Although the proposed changes to the regulatory pathway would pose new challenges for gaining approval of certain new devices, they may contribute to the continued increase in new financing opportunities for RM and RIF investors.

Product-Based Financing

RM and RIF are similar but distinct forms of product-based financing. In both types of transactions, companies sell all or part of a royalty or revenue stream that would typically be received over time in exchange for an up-front cash payment. Although typical transactions range from $20 million to $45 million, some have been below that range and others have exceeded $100 million—a substantial bolus of cash that can be deployed to develop or launch new products, expand a sales force, acquire products or companies, or achieve other strategic growth objectives.

RM. Royalties generated by product sales can provide substantial revenue to companies over the term of the underlying license agreement. However, many companies need more immediate cash than what royalties can deliver over time. For example, $100 million paid out in annual payments of $10 million over 10 years has less transformative power than a lump-sum payment of $50–70 million that could be deployed in its entirety to achieve one or more strategic growth objectives. An RM enables a company to access its future royalty payments today, and to use the resulting bolus of capital to undertake initiatives that cannot be achieved with capital that trickles in over time.

Figure 2. Royalty monetization setup.

Take a situation in which an innovator (Innovator Company) has developed a novel technology or product and licensed it to a company that has responsibility for commercialization (Commercial Company). As Commercial Company generates revenue on the sales of the licensed product, it makes royalty payments to Innovator Company (see Figure 1). Rather than waiting for the royalty payments to accumulate over time, Innovator Company undertakes an RM. The RM investor (Investor) provides Innovator Company with cash today and, in some cases, future milestone payments should predetermined sales levels be achieved. In exchange, all or part of the future royalty payments made to Innovator Company by Commercial Company flow to the investor for a defined period of time (see Figure 2).

RIF. RM transactions are highly flexible financing structures with one notable limitation: they require the existence of a royalty stream. Revenue interest transactions were developed to provide the benefits of RM financing to companies that generate product revenues directly rather than receiving royalties on sales made by others. Essentially, an RIF creates a synthetic royalty that can be monetized in a manner similar to an RM. Consider a company that generates revenue through the sale of one or more products (Commercial Company in Figure 3). A synthetic royalty comprising a percentage of these revenues is sold to the investor in exchange for up-front cash. Transactions may also be structured to include milestone payments to coincide with specific times Commercial Company may need additional capital infusion. The defined percentage of future sales revenues then flow to the investor rather than Commercial Company over the duration of the agreement. In addition, RIF is typically structured to provide even greater flexibility because these transactions may include provisions that allow the company to repurchase the revenue interest prior to the term of the agreement if and when additional capital becomes available, or should the company elect to pursue other strategic alternatives. 

Features and Benefits of Product-Based Financing

Both RM and RIF provide unsurpassed flexibility with respect to deal terms. This flexibility enables companies to tailor these nondilutive transactions to best balance their near-term financial needs and long-term growth opportunities. Deals can be structured around one or more products and can comprise all or a defined percentage of the royalty or revenue stream. Tiered structures enable companies to pay a smaller percentage on increasing amounts of royalty or revenue income. This approach allows them to retain a greater portion of a product’s upside potential, as exemplified in the Orthovita example discussed later in this article. Payments to RM and RIF investors may also be limited to royalties or revenues generated in certain geographic territories and for a defined period of time.

Figure 3. Revenue interest financing setup.

Compared with equity-based financing strategies, RM and RIF are nondilutive to equity. As a result, these product-based financing alternatives may be particularly attractive to companies that believe their stock is undervalued. Unlike debt financings, which typically involve restrictive covenants, RM and RIF do not limit a company’s ability to manage its corporate, financial, intellectual, and product assets. This setup may make RM and RIF particularly attractive to companies that want to retain their ability to undertake strategic transactions or merger and acquisition activity in the future.

Beyond providing capital, RM and RIF transactions also help companies reduce the risk of commercial failure. By providing cash today in exchange for future royalty- or revenue-based payments, the RM or RIF investor is assuming a portion of the risk should the product generating those payments fail to perform as expected. Even if payments to the investor are lower than anticipated, the company still retains the cash that was provided at the time the investment was made.

All capital comes at a cost, and RM and RIF are no different. Selling a royalty or revenue interest reduces a company’s future income. Companies considering fundraising activities need to evaluate their near- and long-term priorities and select a financing strategy that best meets those needs. Although RM and RIF are not appropriate for all medical device companies, they do provide companies that have current or near-term royalty and revenue streams with additional, highly flexible options for accessing capital.

RM and RIF in the Medical Device Industry

Given their flexibility and ability to provide capital without equity dilution or restrictive covenants, both RM and RIF have been utilized by medical device companies over the past decade. The following examples demonstrate how product-based financing and hybrid transactions that combine product- and equity-based financing components have been deployed to provide strategic growth capital.

On-X Life Technologies. On-X Life Technologies (formerly Medical Carbon Research Institute), an innovator of a novel pyrolitic carbon technology, is focused on the development and commercialization of implantable mechanical heart valves and other devices. In May 2001, FDA approved the company’s On-X aortic valve, a heart valve replacement product. In March 2002, FDA issued premarket approval for the company’s On-X mitral valve. In November 2002, On-X entered into a $10 million RIF transaction based on the On-X valve and proprietary coating services. This capital was to be used primarily to increase On-X’s commercialization efforts for new product development and other working capital needs.

Orthovita. Orthovita, a developer of orthopedic biomaterials, raised $10 million through a hybrid product development transaction that comprised an RIF and an equity investment. The RIF component of the transaction was based on sales of three Orthovita products, Vitoss, Cortoss, and Rhakoss, in North America and Europe through 2016. Orthovita received $5 million in cash in exchange for a revenue interest of 3.5% on the first $100 million of sales on these products, plus 1.75% of sales in excess of $100 million. The company also sold 2.6 million shares of its common stock to the same investor for an additional $5 million. Utilizing this hybrid structure, Orthovita was able to access important growth capital while minimizing the issuance of stock at a time when the company considered itself to be undervalued. Orthovita used the $10 million provided through the transaction for clinical development, marketing initiatives, and working capital associated with the aforementioned products. The transaction enabled the company to advance its product development pipeline, increase its sales, and move toward its goal of achieving profitability.

These examples demonstrate how medical device companies can use revenue generated by approved products to access nondilutive capital that can be used to support additional growth opportunities. These transactions can be structured to not only provide cash, but also to shift a portion of the risk of clinical or commercial failure from the company to the investor.

Conclusion

The medical device industry is facing a number of financial and regulatory challenges that may substantially alter the way in which companies and investors finance new product development. Successfully addressing these challenges depends on financial innovation as much as it does on technical innovation. Over the past 10 years, medical device companies have effectively utilized RM and RIF to access capital and pursue compelling growth opportunities. These completed transactions provide real-world examples of RM and RIF in action, and today’s medical device companies can look to them as models for meeting their own financial needs. 

The pharmaceutical and biotechnology industries are facing financial, regulatory, and reimbursement concerns of their own, and it is possible for medical device companies to draw on the experiences of their compatriots in these industries as they chart new paths through a changing landscape. In addition to exemplifying the financial benefits of RM and RIF, the pharmaceutical industry also provides models for how these types of transactions can be used to mitigate product development risk. These risk mitigation strategies can also be deployed within the medical device industry. 

Implementation of proposed new regulatory processes for 510(k) medical devices might increase the barrier to bringing new products to market while also providing additional clinical data that better define a product’s competitive profile. The availability of this information may make investment in these products more attractive to investors. Companies seeking to advance their pipelines while mitigating the risks of new product development may wish to consider RM and RIF as strategic options for balancing risk and reward within their own portfolios.

References

1.    JM Donnelly, “Mass. Medical Device Firms Hit Financial Stumbling Blocks,” Mass High Tech, October 11, 2010; available from Internet: www.masshightech.com/stories/2010/10/11/daily58-Mass-medical-device-firm...
stumbling-blocks.html.
2.    510(k) Working Group Preliminary Report and Recommendations, August 2010, CDRH; available from Internet: www.fda.gov/downloads/AboutFDA/CentersOffices/CDRH/CDRHReports/UCM220784....
3.    M Hollmer, “VCs Warn New Device Tax Could Reduce Investments,” The Gray Sheet, April 2, 2010.
4.    21 USC 355(d) (2006 ed.).
5.    Guidance for Industry: Providing Clinical Evidence of Effectiveness for Human Drug and Biological Products (Rockville, MD: FDA, Center for Devices and Radiological Health, 1998); available from Internet: www.fda.gov/downloads/Drugs/GuidanceComplianceRegulatoryInformation/Guid....

John Leone is a partner at Paul Capital Healthcare (New York).