Roundtable: Medtech Funding and Investment

Industry experts discuss the realities and expose the myths surrounding the current financial climate of the medical device industry.

September 1, 2006

44 Min Read
Roundtable: Medtech Funding and Investment

FINANCE

Entrepreneurs operating in the medical device industry take all shapes, from new entrants emerging from academia and related technological and clinical fields to seasoned industry veterans looking to establish and grow yet another successful device enterprise. But no matter their level of experience and expertise, the ultimate success of all medtech entrepreneurs hinges on one thing: their ability to raise adequate funds to bring their ideas to fruition.

Illustration by ARTVILLE

In light of the meteoric growth of the medical device industry in recent years, the field is being peppered by an increasing number of start-up ventures. Although sources of funding still abound, investors today have a wide variety of options when identifying worthy and potentially profitable ventures. An experienced team and solid business plan can make all the difference for an early-stage medical device company looking to gain the interest and favor of the financial community.

To find out more about the current climate for medtech funding and investment, MX recently spoke to six experts in the field (see sidebar). In this roundtable discussion moderated by MX editor-in-chief Steve Halasey, these industry experts discuss funding availability for new medtech ideas, challenges faced by start-up companies, and strategies for success in today's investment environment.

MX: In today's medical technology environment, what kinds of people are most commonly seeking funding for new medical product ideas? Are they predominantly academic researchers, clinicians, or engineers, or perhaps a mixture of these?

Anne DeGheest: In my experience, it is a mixture. I frequently see practicing clinicians, some of whom have teaching credentials, coming up with new ideas for medical products. I also see some engineers coming out of established companies and setting up their own firms to develop products.

Allan W. May: I agree. In one order or another, university professors and postdoctoral researchers, engineers, and clinicians are the three engines.

Lars Enstrom: The backgrounds of the people who seek funding from Fortress typically fall into two categories: clinicians or individuals who have experience at larger medical device or pharma companies.

Have you noticed any change in the types of people who are bringing new medical technology ideas forward? For instance, is the academic community being more or less active than it has traditionally been?

Baiju R. Shah: I can't speak from a national perspective, but certainly within the Midwest—particularly around BioEnterprise's home base in Cleveland—clinicians and researchers have become more entrepreneurial, and there has been a significant increase in their level of activity in developing new medical technologies. However, such activity within this group has historically been fairly low. Therefore, I think this group is now starting to rise to the level of other groups rather than surpassing the levels of activity seen in their counterparts in the engineering world.

Dennis W. Wahr: Useful new ideas often come from people who have not only a window into the current state of the art but also a window into what the market is demanding. The people who have such windows are commonly clinicians. I wouldn't differentiate between academic physicians and those physicians who work at active, research-oriented private practices, of which there are many in the United States.

It is less common for engineers to produce ready-to-go ideas than it is for clinicians. Engineers are more likely to develop a concept, but those concepts often require refinement before they can address an unmet clinical need.

In your experience, how knowledgeable or sophisticated are these entrepreneurs? Are they more knowledgeable than entrepreneurs might have been five years ago or a decade ago?

Jay Watkins: Yes. The root idea obviously has to stem from an understanding of a clinical need. It is pretty rare to see a lone engineer develop something that falls right in step with the needs of a clinical practice. More commonly, these projects represent a team effort.

One of the things that has changed in the idea origination process is that there are many more experienced serial entrepreneurs in the medical device space, including clinicians, engineers, and businesspeople. The teams we see developing include people with deep experience in the industry.

Enstrom: Entrepreneurs are more pragmatic now about products and how they fit into the value chain. We see more business and marketing executives at early-stage companies who have a good understanding of what might sell and how difficult it may be to reach their intended customers.

So, now that they have been through the process a couple of times, are these entrepreneurs more knowledgeable and sophisticated than those of the past?

Watkins: Yes, I think so. We see fewer and fewer green-field, first-time entrepreneurs. More often than not, entrepreneurs have teamed up with somebody who has pretty extensive prior experience.

Are new entrepreneurs seeking out experienced folks because they know that their products will have a need for their expertise, or is it more common to find a group of people working together repeatedly on multiple products?

Watkins: A certain portion of this has to do with the character of our industry. When a person tries to troubleshoot the design of a device, it is not exclusively a clinical endeavor or exclusively an engineering endeavor. Such a situation tends to foster a team approach, and industry newcomers look to form relationships with experienced counterparts.

Enstrom: More clinicians are teaming up with business executives because they realize that it's not good enough to just have a great technology. They need to present the business case for the opportunity and show that it can be commercialized and sold.

Wahr: Recently, I have witnessed several situations in which a successful, senior entrepreneur has independently identified an individual with a promising idea and partnered with the person. In some cases, instead of taking on the role of the project's entrepreneur, the experienced party works with the new entrepreneur in a mentoring capacity, or perhaps as an early-stage angel investor.

DeGheest: Right now, the venture industry is much more risk-averse than it used to be. Having a full team in place can help overcome this resistance. The person who develops the original idea has to work with angels. With a virtual team—or at least the skeleton of a team—of experienced players in place, a project is much more marketable. The perceived reduction in risk can help a team obtain a venture round of funding.

When you first encounter these entrepreneurs, what kind of knowledge do they usually not have that they should work on getting before they seek out investment?

DeGheest: It depends. If the idea comes from a clinician, there is usually a bit of naiveté and lack of understanding of what it takes to turn a clinical idea into reality in regard to cost savings and the value that must be created for buyers, users, and payers. That is one of the complexities of this industry.

If the idea comes from an engineer, there is usually a different type of naiveté involved. The idea may represent a great technology, but it might not respond to a clinical need strong enough to serve as the basis for building a company around it.

May: The conferences that focus on medical devices and biotechnology have become relatively sophisticated. A person can't attend one of these conferences without hearing a substantial panel of people say that entrepreneurs need to associate with industry players who have previously worked on a particular device or technology or clinical segment to help them through the financing process.

Most entrepreneurs do not have experience in company building or commercializing a technology. Entrepreneurs fall into one of three categories. They are either experienced serial entrepreneurs who do not require assistance in the process. Or they are first-time entrepreneurs, in which case they do need that kind of help. Or they are entrepreneurs who have associated themselves with people who have the relevant expertise. Entrepreneurs are going to fall into one of those three buckets.

In all healthcare areas, whether biotechnology or medical devices, the main advice given to entrepreneurs is to not go it alone. Entrepreneurs need to associate with somebody who can mentor them in order to improve their success rate. Often, entrepreneurs don't know how to talk to venture capitalists or angels. They don't understand dilution. They don't know how to arrange their various rounds of financing so that everybody wins at every stage. They don't know how to balance a price with dilution. They don't know how to determine the amount of money to seek in order to hit their milestones. They need somebody to help them do that. That is where the previously stated points regarding teamwork and entrepreneur naiveté coalesce.

Shah: All of this depends on where a person is coming from in terms of the knowledge gap. And it is not just the individual entrepreneur's knowledge gap that must be taken into account, but also the gap existing within the entrepreneur's network. Many entrepreneurs come looking for investment funds when they are not necessarily investment-ready. This is not necessarily due to a lack of mentorship. Often an entrepreneur might not understand how to tap into the resources of advisory boards. These boards are there so entrepreneurs can leverage their networks either to expand into multiple clinical sites or to expand into strategic partnerships or distribution partnerships as the group brings a device toward the marketplace. Oftentimes we see the lead inventor or entrepreneurial team come our way with one clinical institution on board. That is not necessarily sufficient to get serious venture investors excited.

Wahr: It is common for entrepreneurs to have ideas or product concepts about which they are passionate. But first-time entrepreneurs often are not sophisticated regarding the realities of finance and the realities of what is required in preclinical development, study design, approval, and reimbursement areas. It's up to their senior mentors to assist them with these issues, which often prove to be the more challenging parts of the development process.

Watkins: The invention business is pretty simple, but the building of a business is relatively complex. The process is frequently underestimated by teams, whether the principal inventors are clinicians or engineers.

More so than specific domain expertise, I find that first-time entrepreneurs generally lack a set of characteristics. Of those characteristics, patience is at the top of the list. First-time entrepreneurs frequently lack sufficient patience. Secondly, because they are in a hurry, they generally do not ask as many questions as they probably should. The third required piece—and this is a tough skill to perfect—is the ability to tell the difference between good advice and bad advice.


Opportunities and Requirements

In the current environment, how much money is required to take an early-stage medical technology company from start-up through liquidity? Are there particular factors that are driving the cost of medical device development right now more than they might have in other times?

DeGheest: It depends on the type of product the company is developing. For a high-risk technology requiring a premarket approval (PMA) application, right now a company is probably looking at $40 million to $75 million to get to the point of some type of commercialization of the product, as well as a potential exit through an initial public offering (IPO) or acquisition. For a company in which the risk is more market-based and the company's application builds on existing technology—requiring lower levels of FDA scrutiny and lower reimbursement pressures—a company may be able to achieve an exit with $20 million to $40 million. Again, it depends on the type of product.

May: The cost associated with getting a company off the ground is too great. The system is broken. The estimates of about $40 million to $75 million for a PMA and $20 million to $40 million for other devices are correct. Post monies can be $60 million, $80 million, $100 million, and take-outs are very rarely more than $100 million in terms of exits in liquidity. Again, I think the system is broken. The system has to go back to more capital-efficient development.

One factor driving this trend is that big companies have become risk-averse. They are no longer interested in technologies—even technologies that have FDA approval. They want technologies with proven market penetration rates so that they can extrapolate their revenue stream. This forces start-ups to raise money to build manufacturing, sales, and marketing, none of which are of any use to the big players. Therefore, start-ups do not get back any multiple on their money for those investments. Rather, the companies become heavily diluted by raising it. Big companies need to back off that requirement and be willing to take more risk and go in earlier.

For this industry to be profitable in the decade going forward, we have to be able to build medical device and biotechnology companies for less than $20 million.

Wahr: The high cost of building medical device companies emphasizes the need for a team that can really execute and that has the relevant experience to do it without having to backtrack.

Enstrom: In general, I believe the ranges that have been cited are accurate. Clearly, clinical and regulatory expenses have been the major contributors to these increasing costs. Many companies have coped with these expenses by remaining virtual longer or by relying more on consultants rather than employees. Nevertheless, the huge costs imposed on small companies mean that more capital has to be raised before a liquidity event. Companies have to mature to become self-sufficient because early funding from an IPO does not exist now and acquirers are waiting longer before buying companies.

Watkins: One solution is to make start-up companies more capital efficient and ask the acquirers to acquire early. The other solution is to focus on building companies that will last and that are designed to be stand-alone companies over the long haul—companies that don't count on a take-out.

One of the fundamental problems in the medical device industry is the imbalance between the number of companies that are for sale and the number of acquisitions that will actually happen. Even if companies are inexpensive from a development standpoint, it is really tough to sit on a technology and wait for a take-out. If a company is not shipping, not selling, and has no prayer of profitability, that is exactly what the company will end up doing.

Wahr: A key driver of this has been a fundamental change at FDA and also at the Centers for Medicare and Medicaid Services (CMS). Products will no longer be approved based on proof of safety alone. Companies now have to prove efficacy, and that typically will add significant scope and expense to their clinical trials. While this is a good thing for the public's well-being, it has driven up the price and complexity of development substantially.

I assume that you mean not just clinical trials for safety and efficacy but also outcomes research, cost-effectiveness research, and so on.

Wahr: Yes. CMS looks to determine whether a product is reasonable and necessary. This is the bar that companies must clear to get reimbursement.

Watkins: In regard to the perspective of the large-cap acquirers, it is important to keep in mind that the cost of their own trials has gone up. Even if an outside technology was cheaply developed, it puts pressure on an acquirer's budget if it decides to acquire a technology and take it the remainder of the distance in a clinical trial.


Managing Growth

There has been a lot of comment on the dearth of seed funding available to entrepreneurs at the very earliest stages of establishing a company. Is there in fact a gap of funding, and who is filling that gap?

DeGheest: According to PricewaterhouseCoopers/National Venture Capital Association reports, between 1995 and 2005, the combined total of seed- and early-stage funding dropped from 39% of all venture money invested to 19%. That is a very significant drop. This presents a huge hurdle for first-time entrepreneurs who do not have a full team in place that can help decrease the technology risk and market risk associated with a company in order to gain the interest of the venture community.

Angel investors are stepping in. But the problem is that while angels can contribute a certain amount of money, a company must still reduce its risk enough to get the venture industry interested. That gap in funding is widening, so the amount of money the angel investor community has to invest is getting larger and larger. I think that is why some of the angels are getting themselves organized—in order to have enough power to bridge that gap.

Do you think that the organized angel groups are enough to fill that gap? How well are they doing?

May: Yes and no. The Angel Capital Association, a program of the Ewing Marion Kauffman Foundation (Kansas City, MO), tracks this issue. The association publishes data on this and has some slides available at its Web site that are very educational in terms of this phenomenon. The data that have been collected so far—which are very sparse—have been collected for only the past three years. The data indicate that the growth of organized angel groups following the 2001 bursting of the dot-com bubble has been relatively explosive. The number of angel groups has risen from less than 100 to more than 250 in this period of time.

However, their level of investing has remained relatively stable. There is approximately $29 billion to $30 billion nationwide in angel activity. This mirrors the level of venture investing in start-ups, but angel investing is focused at seed-round and early-round investment opportunities, whereas venture investing is focused on commercialization and later-stage rounds.

The Angel Capital Association has data on its site as to the number of companies receiving angel funding. Obviously these data include nonmedtech entities, such as car washes and your uncle's bakery and all that. As for what people consider classic technology start-ups—device and biotechnology start-ups in particular—the data show that angels can take companies through organizational stages requiring $1 million, $2 million, or maybe $3 million. According to the data, somewhere between $2 million and $5 million is the chasm that seems to be a little bit difficult to bridge. It is hard for angels to bridge that gap, particularly those working in the devices or biotechnology industries, in which companies must tie their money to milestones. And those milestones have to demonstrate efficacy or a significant risk reduction to venture capitalists in order to attract their funding. It generally seems to take about $2 million to $5 million to do that, so that is where the gap exists.

Organized angel groups are now beginning to syndicate their deals with one another. Some are looking to raise side funds in order to close that gap so they can control the deal up to the $5 million mark. Being able to do so reduces the risk associated with attracting follow-on venture financing. I think the data point to this phenomenon, but the data are relatively new, and this might be an overinterpretation of them.

We have certainly seen greater specialization among venture capital (VC) firms, and now, with the Life Science Angels and others, we are starting to see specialization in the angel groups as well. Is that a good thing and is there enough of it?

DeGheest: On the medical side, it is absolutely essential. I have friends who are in the computer industry who try to invest in medical deals, and they absolutely cannot bridge the knowledge gap. They cannot get comfortable. There are so many risks, and they don't understand physiology and the industry. They always pass on medical deals. In order to get somebody to take a leap of faith on the technical and the clinical side, companies need to deal with people who have done it in the past and know that it is feasible.

May: There is some specialization in the angel groups, but it is not to the extent that people might think, and such specialization does not occur nationwide. Geographically, specialization occurs where a person would expect: on the West Coast in Northern California, Seattle, and maybe San Diego; and in the East around Massachusetts, New York, and Boston. There is enough deal flow and enough venture capitalists for follow-on financing in these areas to allow for some vertical sector specialization. In most places in the United States where start-ups are emerging, such resources have not reached a sufficient critical mass to allow for such specialization. Therefore, angel groups have no choice but to invest in semiconductors, energy, biotechnology, or other industries. There are fewer than 10 organized angel groups in the United States that focus principally on life sciences or medical technology investing, and most of those 10 do not specialize in it.

Shah: One of the things that I am observing in Midwestern angel groups is that although there isn't specialization at the full group level, there are certainly pockets of specialized individuals within many of the large angel groups. These groups are starting to develop much like multiindustry venture funds. The same model is developing at the angel group level. So if a deal in the medical world presents itself, there is often a group of angels in the area with the relevant experience to evaluate the deal and guide it, should they choose to invest. Having angels with relevant experience helps seed-stage companies get appropriate mentoring so they can advance toward a venture round of funding.

While angels are clearly the largest pool of alternative sources of funds, we're also seeing two additional sources begin to emerge. One is institutions that have captive seed funds that are being used for translation work. Such institutions include the Cleveland Clinic and Case Western Reserve University. There is a growing movement among technology offices of large institutions to have somewhere between $5 million and $10 million available to fund translational work and to hire initial professional management teams.

The second emerging source of seed funding is individual states. Some have stepped forward to fill the funding gap. For example, Ohio has a program called the Third Frontier, which allows institutions to collaborate with start-up companies—whether they emerged from an entrepreneur within the institution or from the outside--and fund the translational work to the tune of millions of dollars. Entities emerging from this program include a neurostimulation center with several spinoffs, as well as a center focused on atrial fibrillation that has several spinoffs. These entities have been able to get the monies required to advance them to the venture world.

What I have not yet seen happen in the device world that I have seen happen in the biotech world is the emergence of disease-specific foundations as financing sources for advancing technologies.

Enstrom: More states have finally recognized that they have a vested interest in creating jobs in new industries to make up for jobs lost in more-mature industries. They have also realized that in many cases state universities offer a great many useful assets both in terms of intellectual capital as well as physical assets, such as buildings that can function as incubator space. One of the companies I recently financed had a partnership with a major university and was housed in a research park on campus. In addition, the state made an equity investment in the company.

Are large medtech companies doing enough, through incubators and medical technology venture corporations, to fund early-stage development? Are the terms involved in getting support from such entities of the sort that entrepreneurs can live with?

Shah: I am not familiar with the terms of professional, for-profit incubators. BioEnterprise follows a unique model in that it does not take a fee and it does not take equity. It has been financed by private philanthropy to perform its function, so I do not have a great perspective on what the incubators require. However, I do think they are a necessary component in this development chain.

Wahr: It seems like there is adequate angel money from the sources already mentioned. From the entrepreneur's perspective, a start-up has to be very careful when considering whether to allow a large medical company to provide seed funding. The moment a company accepts funding from a potential future strategic acquirer, it risks being viewed as a captive company. Down the road, the firm may find that it has substantially limited its potential buyers. The company providing the funding will either have to be the acquirer, or the entrepreneur will be forced to explain to any other potential acquirer why the company that invested in the firm is not interested in it. That is a tricky situation.

Watkins: I agree. Entrepreneurs should go to large-cap funding sources only as a last resort. But there is also an argument to be made that the shortage of early-stage capital is more perception than reality. We have substantially widened the funnel of institutions and individuals that are looking to fund their new medtech ideas. BioEnterprise, for instance, is just one of the many institutions that have responded to the opportunity to innovate and to develop fundable new ideas.

At least in part, it's arguably been this widening funnel of institutions that has created the perception of a funding shortage. It's not that there is no money available. It's that there is a surplus of people who want it and have decided to go seek it.

That surplus works within the context of venture capital as well. So when people discuss the shortage of early-stage capital, they are implying that the traditional venture capital business—which is at all-time record levels in terms of the money raised for device companies—is sending its capital to later stages.

Enstrom: I do believe that there is a shortage of early-stage capital from VC funds. Many funds have moved to later-stage investments, and in several cases partners in these funds who used to invest in early-stage companies have left. The problem is that it is harder and takes longer to make money from early-stage investments in this environment. The dilemma for VCs is that they now have to compete with hedge funds and private equity funds in financing the later-stage deals they are now targeting.

Wahr: It has become very common for large research institutions around the country to develop sophisticated licensing and technology transfer offices. These offices serve two functions: One is to be a regional economic development vehicle for the institution's city or region. The other is to be a long-term source of potential revenue for that institution through licensing agreements. The technology transfer offices of large academic institutions typically encourage and often assist their faculty to develop ideas that can be licensed to independent entrepreneurs. The key to this process is the identification of a talented, passionate entrepreneur. In my experience, it's unusual to find a scientist or inventor who is willing to abandon an academic career. To ultimately attract VC financing, a full-time talented entrepreneur is essential.

DeGheest: The problem with those types of ideas is that they are usually missing an entrepreneur.

Wahr: Exactly.

DeGheest: There are academics who want to stay in the academic world. They have to show some kind of technical proof of their work, but they have no grasp of the business side of moving an idea to commercialization and, more importantly, they lack the passion to risk their livelihoods to make it happen.

Wahr: The quasientrepreneur in that setting—often a tenured professor in a university—is typically not interested in running with an idea and giving it a 100% effort. That person is commonly most focused on the creative process. The quasientrepreneur may participate in the commercialization process as a medical advisor, but that person typically will keep their day job at the university for the long haul. Concepts that emerge in the absence of a passionate entrepreneur will face a long road in pulling together the team of ambitious, talented, dedicated people required to make the product a reality.

Shah: It is in situations such as this that the better technology offices—those that have a captive funding source, whether it is a seed fund or just operational funds—are smartly investing in management rather than just investing in additional validation work for the technology.

Do academic and clinical institutions have a realistic sense of what it will take to commercialize their intellectual property, and therefore what its value is likely to be?

Shah: This varies on an institution-by-institution basis. The ones that are more experienced have a realistic sense of what the value of a bucket of IP is. They have realized that not only is patenting important but freedom-to-operate opinions and the like are also important if the institution is going to commercialize its technology. These experienced institutions have the sense that their intellectual property alone might not be the basis of a company. It might need to license technology from other sources. In negotiating its deal terms, the institution might also have to make sure it is accommodating the needs of a venture group or a corporate licensor. But again, experience varies on an institution-by-institution basis.

The technology transfer industry is much younger than even the venture capital industry. Technology transfer arguably started in 1980, but most of the programs at large research institutions did not start until the mid-1990s. There is still a lot of learning to do, and there are very few institutions that are experienced enough to operate in a way that the VC firms would appreciate.

Enstrom: There is great variability by institution. Technology-focused organizations that are located on the East and West coasts tend to have very developed groups. They understand the markets well and recognize what it will cost to commercialize their IP.

Even if it is not directed at early-stage ventures, does the overall availability of capital increase the number of companies that are looking for investment?

Watkins: Yes. Like everything else, this is a business of cycles. And in this cycle, the headline news is that there is plenty of money for medical technology investing. This encourages entrepreneurial teams to make their pitch. Due to the favorable environment, they think that even an idea they might have abandoned a couple of years ago might have a chance of getting funded. So there is a clear relationship between the amount of money that is available and the number of plans being presented. Back in 2001 and early 2002, there was not nearly the same level of capital available for investment that there is now, and entrepreneurial activity in the medical device industry was noticeably lower as a result.

Does this improve your range of investment options? Looking forward to next year, are there certain sectors that you find particularly attractive?

DeGheest: One problem is that some sectors are overserved. There is too much money chasing deals. Therefore, the valuation goes up, the quality of the return goes down, and the team gets split between different companies. The cardiac, orthopedic, neuro, and some ophthalmology sectors are ones that I would say are overfunded.

On the other hand, there are many other areas that are underfunded, including those in which people are trying to develop more-efficient ways of practicing medicine, such as new technology for healthcare information systems. These companies have always had problems getting initial funding because their intellectual property and patents are usually weak and they are trying to change certain behaviors in hospital settings. So it really depends on the sectors.

Wahr: Despite the fact that there is more venture money for life sciences out there than ever before, or at least as much as there has ever been, the number of investigational device exemption applications and investigational new drug applications to FDA is down substantially. Because of how difficult the regulatory environment has become and how large the trials need to be, VC firms are becoming much more sophisticated and selective about the concepts they fund. However, when they do choose an organization to fund, they are willing to put much more money into the development of those fortunate companies.

Many people are surprised when they hear of the decline in applications to FDA supporting novel products or drugs that require formal premarket approval, but they are down substantially.

May: Within the industry, there certainly exists a herd mentality. If one investor funds an interventional pulmonology company, then six other people also fund interventional pulmonology companies.

But in general, the opportunity is the opportunity, regardless of what sector it is in. If you consider the nine or 10 deals Life Science Angels has in its portfolio, I'm not certain there are two in any particular sector. These deals are particularly idiosyncratic, and they depend on the strength of the team, the IP, and the market opportunity.

Is the rise of China affecting funding and investment in medical technology companies?

Wahr: I have not seen it at all in our group.

Shah: Same here; there is no impact.

Nevertheless, we are hearing that many industry suppliers are opening facilities in China to take advantage of its low wages, reduced regulatory burden, and so on.

May: I am also seeing this on the clinical side. Many venture firms have ongoing clinical trials in India or China—or certainly in places other than the United States or Europe. I am seeing a lot of outsourcing. I am seeing it in generic biotechnologies, and I am seeing it in clinical trials and regulatory work.

But I am not seeing it in investment. People still want to invest in U.S. companies, but those U.S. companies are trying to manage their capital efficiently by utilizing offshore suppliers and consultants.

Wahr: From the perspective of product development and clinical trials, there is no question that countries outside the United States are becoming progressively more important.

Watkins: The exception is investment. The technology centers are in the United States, and that is where the investments are made. Operational outsourcing is a different situation entirely, and we are seeing a lot of it.


The Virtual Strategy

Do you exert pressure on companies that you fund to get them to adopt a virtual company model?

DeGheest: The ultimate market is the U.S. market, so an idea has to solve a clinical need in the United States. But how a company decides to fulfill that clinical need varies. The engineering of software can be outsourced to India. As for clinical trials, clinical research organizations are starting to get very good quality out of China. So in order to be capital efficient and time efficient, companies are outsourcing some of their product development.

Wahr: The largest medical market by far is the United States. All companies must have entering the U.S. market as their main goal. A company can conduct research anywhere it wants, but regardless of where the research is conducted, it must meet the regulatory standards of FDA to get approval in the United States. The practical implication of this is that it becomes difficult, if not impossible, to do FDA-quality work entirely on a virtual basis. We are not in favor of virtual companies.

How are companies identifying outsourcing firms with the kinds of expertise that they need in these various areas?

Wahr: That is the challenge. It sounds great: go to India, do your clinical trial, and perhaps do it for 50 cents on the dollar on a per-patient basis. But the art of the game is to make sure that the data coming out of the trial are high quality. A company must maintain FDA standards. If the data are bad, incomplete, or poorly documented, it is like the trial was never even conducted. But the good news is that high-quality research institutions are springing up all the time in foreign countries.

Watkins: This process happens continually. I recall similar discussions dating back 10 to 20 years ago regarding whether companies should send their manufacturing offshore to South America or whether they should send their clinical work over to Europe due to the difficulties companies were facing in the United States. Investors are asking companies' management teams to stay awake to such opportunities. But at least in the case of China and India, this process is still in its early stages, and the pathways have not been well mapped yet. There is not an organized process under way, and it is a little chaotic at the moment.

DeGheest: In the medical technology sector in particular, it is very important that the product a company is developing can be used by American customers. So if a company outsources too much, it loses the iterative development process that is typical of medical technology products. It is typical for a company to develop its product, get feedback from users, and then modify the product. If a company moves this process to a different country, it may lose some important user feedback.

Are there enough outsourcing firms with the right kinds of experience in various other parts of the world?

Wahr: There are some opportunities, but companies have to be highly selective. Outsourcing is a developing area. It sounds easy when you say, "Let's just go there and do it." But the devil is in the details, and the execution of these groups is what is most important. Outside of the United States, there is a relatively limited number of places where a company can do clinical research studies at a level of quality that satisfies the regulatory requirements of FDA.

May: I recently attended a Kauffman Foundation meeting at which eight or 10 U.S. states were represented, along with eight or 10 angel groups from across the United States. They asked the same question: How can we get angel investing going throughout the United States and enhance entrepreneurial activity and competitive advantage throughout the United States? The general consensus amongst the states that were present was that, aside from the geographic corridors where large amounts of venture capital are being invested, the infrastructure is not in place to support such activity.

In many states, start-ups tend to be measured in terms of people employed and brick-and-mortar facilities occupied. But in more-sophisticated areas, companies are emerging with fewer employees and less bricks-and-mortar, under models that rely heavily on outsourcing and consultants. Outside of the California corridor, the Boston-New York corridor, and maybe the Duke Triangle, there doesn't appear to be adequate infrastructure to allow companies to ride this capital efficiency wave of outsourcing.

Wahr: I am not a believer in virtual companies. I am a believer in companies in which people sit there every day and grind the work out. To be successful, the majority of these companies have to be located where there is a critical mass of all of the resources that it takes to build a company. For companies that are trying to get started in a brand-new area of the country where there hasn't historically been an industry presence, it is going to be much more difficult.

Shah: In the private equity world, there is a growing interest in creating scale operations to support virtual enterprises in areas such as contract design, engineering, contract manufacturing, and clinical research here in the United States—not necessarily offshore. It is primarily to fill that gap. It has already happened on the biotech side, with companies like InChord. That company is an example of a soup-to-nuts provider that takes a product into the marketplace itself. That has not yet happened on the medical device side.


Exits

What are the current expectations of investors in terms of a timetable for exit? When they think about an exit, do investors generally lean toward acquisition or IPO?

DeGheest: It depends. If it is an angel investor, the group is usually slightly more patient than the venture capital industry, which has to return its money to its limited partners.

Everybody would love to reach an exit four to five years from the time of investment. And everybody would like to get a seven times or a 10 times return on their investment. But if you look at the top quartile, the reality of returns in the industry is two to three times, over a period of five to six years.

The IPO market is dependent on the public sector. In medical technology, acquisitions represent a majority of the deals. Unfortunately, the two to three times returns are only seen by lucky companies. Companies are spending more and more time developing and commercializing their products so they can be acquired. Therefore, their returns are getting lower. Companies must invest more money and more time, yet the mergers and acquisitions (M&A) exit garners the same price.

Enstrom: VC investors have typically relied on IPOs as liquidity events. The problem with IPOs is that the window opens and closes rapidly, and it's also hard for VCs in all but the largest IPOs to exit within a reasonable amount of time. This inability of VC investors to exit makes an IPO not a liquidity event but rather another corporate structure with which to raise capital. So, in the case of an IPO, a VC could be in the investment for seven years or more. For these reasons, VCs are beginning to realize that an M&A takeout is really the only true liquidity event.

May: Again, I think the system is broken. The reason that three-quarters of the venture-backed medtech firms in the United States underperform the S&P 500 index is not because they are not smart, don't work hard, and don't have capital. It is just bloody hard to do this. It takes a lot of teamwork, effort, technology, intellectual property, luck, and myriad other factors. It requires too much capital—the model is broken.

I don't know any other business in which three-quarters of the people in the business can lose money relative to putting their money in a mutual fund—and still stay in business. Over time, the country is going to realize this model is broken, and it has to become more capital efficient. People never hear about firms that are not in the top quartile, but there are three-quarters of them that are not.

The industry has to go back to doing this in a different way or else the returns are not going to be there for devices. The exit is going to have to be M&A. Relying on an IPO market in which there are less than 20 to 50 offerings a year does not make any sense when there are hundreds and hundreds of device and biopharma start-ups.

If companies are to realize reasonable returns, mid-cap exits with smaller earnouts in which a company can sell with a $20 million front end and a $50 million to $80 million back end are going to have to become the norm for deals. The amount of capital is going to have to be ratcheted back to produce at least a three times return.

Wahr: Most medical device or biotech start-up companies are one-product companies, and the IPO markets don't like one-product companies. That is the dilemma that explains why most of these companies are going to exit by M&A.

DeGheest: The problem lies with the venture industry. VC firms see these bad returns. They quickly throw together virtual device companies and then exit them within three to four years through M&A deals. There are start-up companies in the medical technology sector that could become billion-dollar companies, but they do not fit into the timetables and business models preferred by venture capitalists. Much of the venture industry takes a cookbook approach to investment.

Watkins: Entrepreneurs need to show patience, and there is an argument that the venture community would do well to do the same thing. Capital efficiency is part of the issue, but doing smaller, cheaper deals is not the only way to create value through M&A. The counterargument is that if people would be a little more patient with companies that start as single-product companies, investors would realize substantial value.

There are more than a few examples of companies in which that was the case. In the past 10 years, we have witnessed this with Kyphon, ArthroCare, and Intuitive Surgical. Those companies did not make investors a whole lot of money in the five- to six-year framework in which investors are looking for the two to three times return. But they made multiples of that return eight to 10 years out.

These are 10-year funds. As investors, we have lost sight of the fact that the worst time to sell these companies is right in the middle of their development when they have values that look to be two to three times the invested capital. There may be an argument for doing this in the case of some companies, but for selected companies, there is clearly going to be the opportunity to develop big value further out by going the distance and building real companies that can stand alone. In light of the current M&A dynamics, that prospect may be more attractive than it has ever been.

May: There are and always will be places for higher capital plays, larger raises, and factors that truly change the dynamics of the medical device and biotechnology industries. Those areas are the perfect places for venture capitalists to place their bets.

Wahr: I personally believe that every company should be built from day one to be a go-it-alone company. Companies can never bet on the fact that they will be able to orchestrate an M&A. Additionally, when entrepreneurs focus on a fast, near-term M&A, it can create problems with their company's development that will slow overall development should the M&A not materialize.

On the other hand, when companies cross the crucial line from the development stage to the commercialization stage, they require much larger sums of financing. This is the point at which they will need to develop their own sales forces and marketing teams. An M&A transaction often makes sense at this point because the acquiring company typically already has the sales force in place. If an M&A does not materialize at this point, the company will need to raise large sums of cash from VC firms, develop its own sales force, and point to a future IPO.

By virtue of having another year in development, some companies have managed to apply their technologies as a platform across a number of areas that they would not otherwise have been able to explore. That is giving them a lot greater success in markets they didn't anticipate when they were just single-product companies and had pressure to get to liquidity fast.

DeGheest: Most of the deals we have discussed were high-technology risk deals going after an existing market. The problem is that now it takes more time to go through the FDA process and show cost savings and clinical efficacy. Therefore, at the five- or six-year mark, companies are just getting to the point at which they have some early product sales and they start booking some sales. That is the worst time to sell because a company's true market value is created when it begins getting its products out on the market.

One opportunity that the medical device industry has not seized is to target new companies that have high market risks and look to create new applications through combinations with existing technology, such as in the computer and telecommunications industries. Products emerging from these combination deals have low FDA and low reimbursement risk, so companies are able to have early sales within a period of two to three years. At that point, they may see a huge increase in valuation.

An example of a company that followed this model is Visicu, which went public several months ago under the symbol of EICU. The company produces a system for the electronic monitoring of patients in the intensive care unit (ICU). Another example is a company called Pyxis. Both companies had low levels of IP, but they were able to achieve huge increases in valuation and very high returns for investors within a period of six to seven years. That is because they were able to have sales within a period of two to three years.


Revenue

How important is a company's reimbursement planning when it makes its initial approach to an angel or VC investor?

Wahr: CMS administrator Mark McClellan, MD, PhD, recently released the agency's new national coverage determination guidance document. It is a very worthwhile read because it clearly states that to get reimbursement, companies are going to need to have evidence from their clinical trials that their medical products pass the reasonable and necessary requirement. The safe and efficacious requirement of FDA is only the starting point. It is very important for companies to formulate their reimbursement strategies early in their development processes and build the necessary clinical evidence. For this reason, a company's reimbursement strategy is a key part of the VC investor's due-diligence process.

Shah: It is important for companies to design a product's clinical development and trial protocols so that the data captured support the health economics of a product. It is equally important for a company to target its market introduction. The company must ensure it is going after high-value applications and developing high-tier devices rather than starting itself off at a low value point and having to fight its way up the ladder for reimbursement.

DeGheest: Reimbursement planning is absolutely essential. The first question I ask companies is, 'So what? What is the value that you bring to all the different players?' The problem with the medical technology industry is that the users, the payers, and the buyers may be three different entities, and companies need to have a value proposition for each one—for the hospitals, for the clinicians, and for the payers—if a product requires reimbursement. Most companies focus on one of those players, but if companies do not have a nice value proposition for all of them, along with the justification from the clinical trials, they may be dead in the water.

Enstrom: This is an absolute necessity for funding. We have to know that companies have a well-thought-out reimbursement plan.

May: I'm not certain having a reimbursement plan is any more or less important than it has been in the past. It has always been extremely important. But from an angel investor standpoint and from the standpoint of the venture firms that come in behind the angel groups, it is fundamental for companies to have a credible plan, know how they are going to approach reimbursement, and be able to articulate their strategies. I've heard companies say, 'We are going to build it, it is going to work, of course we are going to apply for a current procedural terminology code, and ultimately we are going to get it.' Such companies have a much more difficult funding and operational path with both angels and VC firms. Last Thoughts

What single piece of advice would you offer to entrepreneurs who are seeking funding for an early-stage medtech company?

DeGheest: You need to be a missionary, not a mercenary. You need to have the passion to go for the journey.

May: There has not been a better time to be in the biotechnology or medical device industry since the early 1980s. This is a great time to be in the business. The needs are there, the business dynamics are there. Don't mess around with incremental improvements to existing products. Go for products that change the nature of medicine—but don't try to change the practice of medicine too much. Change the cost structure and benefit patients, and you will do very well in this business.

Shah: My one piece of advice is to build an advisory network early that is going to be able to help guide you through the multiple facets of bringing a product to market, getting a company financed, and ultimately getting clinical acceptance.

Enstrom: Spend the time needed to create a thorough business plan. Make sure you understand your company's value proposition and are able to articulate it succinctly.

Watkins: Despite hundreds of years of effort, the medical industry is still left with huge unmet clinical needs. And we have a technology vocabulary the likes of which we have never seen in the history of mankind. If we cannot come up with great solutions out of this situation, then shame on us.

I encourage entrepreneurs to remember that when they look at broad trends, they are looking at averages. The important factor to consider is the quality of their own deal. They shouldn't give up because the average tells them that it is harder to get early-stage capital than it used to be. They should recognize that there is capital available for those ideas that are worth the effort. They need to have the patience to deliver on the promise of their ideas.

Copyright ©2006 MX

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