Costs have risen significantly, yet returns are robust.
“In the 2000s, venture capital investments in healthcare and life sciences outperformed venture investments in tech.” Device company executives could be forgiven for not having seen this recent quotation in a business press that tends to tout venture investment success by the likes of Facebook and Zynga. This observation is from “In defense of life sciences venture investing,” a recent article in Nature Biotechnology that has been picked up by other heavyweights in the device industry.
|Bill Evans, founder and president of Bridge Design|
That quote sits in stark contrast to a fact apparent to anyone close to medtech over the last decade or so: the costs of bringing products to market have escalated significantly. This state of affairs has been quantified and publicized in a survey titled FDA Impact on U.S. Medical Technology Innovation by Josh Makower, a medtech entrepreneur. “The average cost of taking a product through 510(k) clearance is $31 million, and the average cost of getting a product through PMA…is $94 million (excluding reimbursement and sales/marketing activities),” Makower reports. “For U.S. companies, these mounting costs are unsustainable in a venture-backed industry where [fewer] than one out of four medtech start-ups succeeds, 50% of all reported exits are less than $100 million, and the total pool of available investment capital is shrinking.”
These source articles reveal two seemingly contradictory trends over the last decade. On the one hand production costs have risen significantly; on the other, venture-investing medtech returns have outperformed tech investments at a time when it seemed that all the VC action was with Internet-related plays. Both are true. Digging deeper reveals how various investors, entrepreneurs, and other stakeholders have reacted to these changes. This exploration in turn uncovers what the next three to five years of medtech investing may look like.
A survey of historic financial data will not necessarily show today’s medtech entrepreneurs where their funding will come from in the near future and what the next set of investors is likely to care about. At least four structural changes in the market account for this state of affairs:
• Shifts in investment amounts, timing, and risk appetites of venture money sources.
• Increasing regulatory and reimbursement pressures.
• Globalization of medtech funding and newly emerging markets.
• Increasing emphasis on the overall cost of outcomes in a world of escalating healthcare costs.
The good news is that medtech investment insiders all seem bullish on the industry. Robert Curtis, CEO of Respira Therapeutics and a seasoned medtech chief executive with 10 start-ups, notes: “There have been some great successes in the device industry; it’s probably one of the most resilient of the regulated industries in the U.S.” Makower hopes “that brighter days are ahead. Medtech is a good place to invest in the future, but those involved must be exceptionally selective.” Reports on the latest medtech funding numbers support this optimism, showing an increase of approximately 33% in the first quarter of 2012 compared with the same period last year.
Of course, investors of any kind have always been selective, but anyone who has tried to raise money over the last few years has felt the chill wind of this exceptional selectivity. It affects who funds entrepreneurs and when they’re funded, and it creates bigger hurdles for a product to overcome.
The current environment has scared a lot of investors off, changing where the early seed money is more likely to come from. Casey McGlynn leads the life sciences practice of the law firm Wilson Sonsini Goodrich & Rosati (Palo Alto, CA), which over the last two years helped privately raise about $1 billion for medical device companies. “Our industry has spent a lot of time analyzing and complaining about the performance of FDA, and rightfully so,” he notes. “Congress has heard us, and the institutional funds that invest in VCs also heard us, and I think we scared them about the difficulties our industry is facing.”
Compounding this regulatory tightness was, of course, the global financial meltdown. Curtis says that medtech started to feel the effects a little before 2008. “The financial market started to get constipated; money wasn’t flowing well. When that spigot got cut off, the funds looked at what they were doing and instead of investing in early stage start-ups they invested in later rounds of more mature start-ups because they could foresee getting to an exit earlier. On top of that came a shutdown in the IPO market, so for the most part, device companies couldn’t raise money from the public over the past few years. The sole exit has been to be purchased by a big medical device company.”
These pressures have lead VC firms to become more specialized. “Today’s VC firms don’t make the mistake of dabbling in areas in which they are unfamiliar,” says Steve Halasey, vice president of the Institute for Health Technology Studies (Washington, D.C.), which supports independent research and educational activities focused on medtech. “Firms have become increasingly specialized, even to the point that medtech VCs who have a strong interest in a sector such as cardiology might not deal in another area such as IVDs. For the investors who know what they’re doing, there’s no question that the returns in the medical device area have been very good.”
Regarding investor returns, Jonathan Wyler, a principal in SV Life Sciences (Boston) who specializes in medical devices, says, “On average in medtech it’s seven years until an exit, but many of the successful companies of recent years have taken over a decade to reach acquisition. This is a very long time horizon, and hence investors have to support the organization for a longer period, which means considerably more capital. To manage a venture fund to a three-times return, and because returns on successful medtech investments are generally not as high as in tech, it becomes critical to manage loss ratios by identifying the losers more quickly, manage to get your money back on as many as you can, and to avoid expensive investments with binary outcomes.”
This approach makes it harder for VCs to invest early in companies where outcomes are inherently less certain and holding periods are longer. “VCs are not running to invest in very early stage companies,” Wyler says. “Most are buying in later and looking for attractive economics, and much less frequently making an exception for only the most [distinctive] earlier stage opportunities with the very best teams.”
On top of these pressures VCs are feeling a chill from the institutional investors when they go out to raise their own new funds. “The risk-return in medtech relative to the substantial capital needed to get to an exit is different from the tech world,” Wyler says. “Institutional fund managers who are investing in many different asset classes are generally not into the detail of a particular product category or science, but [they] do recognize the headline level themes—depressed markets, challenges with FDA, healthcare reform, acquisitiveness of consolidators, and so on—and often generalize such issues to the entire medtech space. This complex environment has given large institutional funds pause in terms of investing in healthcare. However, these regulatory and other hurdles do create value-generating barriers, and with the right experience and expertise, such risks can be managed to create long-term value in a manner that is not typically present in the tech world.”
Historical returns from VC healthcare funds “are more consistent over time” than the high-profile IT and software successes, according to Rich Ferrari, cofounder of De Novo Ventures (Menlo Park, CA). Formerly CEO of two successful VC-backed, publicly traded medtech companies, Ferrari adds: “There are bubbles in technology, consumer, and electronics. When you look at healthcare, over the last decade or so, it really doesn’t have bubbles. It has a consistent gradual increase. Some returns in IT and technology look good, but they are small in numbers compared with the thousands of companies that are funded. So actually, healthcare does have a better [internal rate of return]. But the environment today for raising money as a healthcare fund is difficult. The institutional investors in VC funds look at these headline big IT returns and their 10-year return in healthcare, and they are not pleased with it.”
These twin pressures on the investment dollars available for VCs, both into and out of their funds, have meant other sources of funding have increased, especially for early-stage ventures. “Angels are alive and well,” says McGlynn. “At the earlier stages of a company they’re more active in putting more money in than ever before. In many ways the Series A venture financing is now being done by angel investors. To lure a five-star VC firm and build that first syndicate you really need to have a great animal beta, a great prototype, and in some cases even credible human data. We are doing a lot of early-stage work with angels and what you might think of as micro-venture capitalist funds. They’re slightly more institutionalized than just an individual investor.” Examples of very early investors, McGlynn says, are Aphelion Capital, X/Seed Capital, and MedFocus Fund. Angel groups include Life Science Angels, Angels Forum, and Bank of Angels, he says.
Another group of angel-like investors, family funds, is gaining momentum, particularly in Europe, Curtis says, “where the family funds model is more advanced; and in the Far East, places like Singapore, which has some fairly sophisticated investors.” McGlynn has also seen Asian sources of funding rise: “We see companies looking for capital in Singapore and other Asian countries where they can set up R&D at a low price, get grants from the government, and raise money from what you’d think of as offshore angel investors.”
“There’s a resurgence in corporate venture capital,” says Curtis. “In the 1980s a lot of companies like Medtronic, Pfizer, and Boston Scientific invested in deals directly from their balance sheet. They then retrenched, but recently I have noticed that more corporations in pharmaceuticals as well as medtech have formed venture funds, or have partnered with experienced funds to invest in start-ups. These companies are beginning to invest broadly. As an example, Pfizer has invested in a couple of medical device deals that could replace pharmaceuticals in some areas. One is NovoCure, which uses a device for glioblastoma therapy. Novartis has looked at medical device deals. So far, not many of these funds are willing to invest in early stage deals, but at least the corporate interest has increased.”
The list of device companies with recently established corporate venture funds includes Covidien (August 2008), Abbott (June 2009), Baxter (July 2011), and Philips Healthcare (August 2010). These companies join the parade of existing players like Novartis, Medtronic, St. Jude, and Kaiser, all of which have longstanding venture investing arms. “The corporations in general have really stepped up to be major funders of new medtech companies, all the way down to the seed level,” notes McGlynn. “The business development people at these large medtech companies are very sophisticated people; they do their homework, they’ve got huge domain knowledge in their specialist area. They’re a bit more targeted than the venture capitalist. I think they’re under a tremendous amount of pressure to help find and fund the best new projects, and the exit might be a little bit earlier to the corporate investor than the venture capitalist. We just started a company with really exciting technology, and Covidien was the first investor.”
“European venture funds are interested in investing in medtech companies that have a CE mark and want to commercialize in Europe,” McGlynn says. “So these late mezzanine rounds where we used to have a lot of interest from domestic VCs now have a lot of interest from international VCs.” He also notes that grants are a big source of capital today. “There’s a lot of money through DOD, SBIR, and NIH grants, as well as from foundations with an interest in the area a new venture is addressing.”
Curtis has seen a change in attitude about grants. “I think government grants are going to be increasingly important,” he says. “For the past 10 years, the venture community looked down their noses at device companies that received grants. Grants are attractive from a founder’s standpoint as they are non-dilutive, but it sets a government-financed research culture that the VCs find not very entrepreneurial. The state of Texas, for instance, has made two very large funds available for grants to Texas-based start-ups. Some states realize the benefits of doing this and will be able to stimulate their entrepreneurial economy.”
Makower hopes for a new stable FDA environment because of these three changes:
• MDUFA guidance will be modified to incorporate key stakeholders feedback.1
• This legislation then passes, improving the efficiency and predictability of FDA.
• When it does pass, FDA quickly and vigorously pursues the changes needed for it to take effect.
Ferrari is optimistic about the near future. “I think we see that FDA is very serious about trying to make appropriate changes to streamline the system,” he says. “There’s a lot of effort going on between AdvaMed and other lobbying and industry groups working with FDA. I think we’re going to see improvements. It may still take us two to three years, but there is a tremendous amount of pressure from Congress to change the system. I think politically it’s going to happen.”
Makower sums up advice for those device companies currently looking for early venture cash: “You need to be aggressive [and] resilient, and if you believe in what you are doing, don’t give up. If you have a choice of projects, choose one where the regulatory path is clear.”
Keeping your venture lean has become the new mantra to allow sparse investment dollars to go further. “Don’t quit your day job until you’ve made some progress with your new product,” Curtis advises entrepreneurs. “Make sure that every dollar goes to moving the product forward in the early days to get to a major milestone, like first-in-man. Then you’ll be better able to go out and raise more money at a decent valuation. Entrepreneurs should look at being entrepreneurial within the context of what they are already doing, and find other people who are interested in doing virtual incubation, making progress working evenings and weekends. There are some very smart and dedicated people in this industry. I think they’ll find new ways to do things faster, cheaper, and better.”
Ferrari also counsels a lean approach. “If you are going out to raise a seed or early round, the best validation to raise money is if you’ve already got some angel money or put some of your own money in,” he says. “If you haven’t done that, [then] when you pitch you’ve got to have a well-thought-out game plan. It might be best to approach the problem in small bites. For example, instead of asking for $10 million now, just raise $2 million, set up some very tight milestones, and run an efficient operation. Mitigate the risk of the program and then go on to raise the next piece. Inch your way along until the risk gets wrung out of the program. That’s a very efficient way to run a company, and the way we used to run them a decade ago.”
Wyler believes today’s leanness means something different than before. “I think it’s much harder to be the cliché engineer in the garage,” he says. “It’s a lot tougher today to go on your own as a first-time entrepreneur. Team up with proven people with a proven process. Connect with the incubators, connect with the successful entrepreneurs who have relationships with investors, and recognize that fundraising is likely to take longer and require more creativity and persistence than in the past.”
Demographic trends still make the medical device business an attractive investment opportunity. “At the end of the day,” says Ferrari, “I still believe that healthcare is an important component to have in an asset allocation model because you can’t get away from the fact that the population of the world is growing older faster than at any other point in time. And we need healthcare. We want the best devices and drugs, and to go to the best medical centers. This is not going to change.”
“Be tenacious,” McGlynn advises medtech investors, because the industry is still healthy. “We continue to close a lot of early-stage rounds. This is a great age. There are some incredible ideas out there. I’ve seen that entrepreneurs need to be leaner. They’ve understood they have to move their products farther before they’re going to be eligible for venture financing. So I’m very bullish about the industry. For those who are tenacious and have a great idea, there’s going to be money.”
1. Medical Device User Fee Amendments of 2007 expire September 30, 2012. Congressional committees had planned to move legislation by April 2012 and have the new measures passed by both the Senate and House by early summer.
Bill Evans is founder and president of Bridge Design (San Francisco), a medical product development company. He can be reached 415/487-7100.