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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.

Structural Changes

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.

Where Will VC Money Come From?

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.”

Angels ‘Alive And Well’

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.”

Corporate Venture Investing

“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.”

Other Funding Sources

“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.”

Regulatory Climate And Reform Hopes

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.”

Advice To Entrepreneurs

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.”

References

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.

Of course, executives can’t predict the future. However, looking toward distant horizons and developing an appreciation for where the medtech industry is in the current upheaval process can lead to betterinformed management decisions.  Even when predictions for the future lead in the wrong direction, they can still offer solid vantage points from which a company can adjust its route.

Venture Advisory Boards

Companies seeking strategic innovations should strike a balance between internally driven initiatives and incorporating external perspectives.  Historically, the innovations that have disrupted industries or created new growth opportunities have rarely come from established companies.  “Internal approaches to innovation are critical since priorities, commitment, and investment for the future must come from within,” says Soren Kaplan, a principal at strategic innovation consulting firm InnovationPoint (Piedmont, CA). But he also notes, “Incorporating the external viewpoint—from industry thought leaders, consultants, academia, start-ups, customers, and partners is absolutely essential for moving beyond today’s assumptions and identifying beyond-incremental opportunities.”

One of the methodologies Kaplan advocates is the establishment of a venture advisory board to provide an immediate infusion of outside expertise into the organization.“By pulling together industry experts with complementary perspectives and inviting them to join an advisory board focused on future growth opportunities, companies can create a new capability that delivers significant new insight almost overnight,”Kaplan says.

Such venture advisory boards are similar to the industry advisory boards that are becoming popular among progressive medtech companies, which seek a panel of outside experts to advise on the customer and disease-management trends within given specialties. The difference is that venture board members are chosen based on their perspectives outside of a particular medical specialty. In fact, they may not even be from the medtech industry. For example, a company might be interested in longer-term healthcare trends in the wireless networking arena. To gain a broader perspective, a company may invite a senior executive from a software and network solutions provider to join its venture board. To reciprocate, an executive at the medtech company might consider taking on a healthcare trend advisory role at the software company.After all, the business of technology forecasting is a two-way street.

Future Forecasting

In forecasting future scenarios, most companies look at existing trends and extrapolate from there. If they are creative, they may even explore the implications of intersecting trends within their industry.  While this might be useful in near term predictions, it is less useful for the longer view.  According to Kaplan, “Real growth opportunities don’t usually come from looking at what everyone else can already see. The longer-term breakthroughs result when companies consider alternative future scenarios—ones that incorporate potentially disruptive trends and events beyond today’s radar screen.  Of course, the goal is to tie all this back to your current business, but you need to start with the future and then jump backward from there.”

To create a future scenario that looks at prospects 10 or 20 years into the future, a company will need to poll a variety of sources, beginning with its internal R&D staff who are immersed in near-term technical trends and attend all kinds of industry forums. The marketing team and others with substantial customer contact should also contribute information that might hint at broad social and technical trends that may influence customer expectations. The company may also poll existing advisory boards and seek input from experts outside its immediate sector—especially from those who are in a position to know of disruptive technologies that might have a large effect on a long-term scenario.

The types of elements that might be expected to arise as part of a future scenario—in this case emphasizing developments that could influence the business of a company with a specialty in patient-monitoring technologies. Some aspects of this scenario are based on a linear extrapolation from present-day products and technologies—such as the development of intelligent implants and broader use of information technologies—showing how the synergies of intersecting technology trends may result in new products and market opportunities.

However, the illustrated scenario also incorporates two disruptive events—developments that cannot be predicted but could have a nonlinear influence on the product and market opportunities available in the future. By considering several such disruptive events, companies can ensure that their future scenarios move beyond mere description of step-by-step product development to reveal events with true market-altering potential.  In the case illustrated here, the disruptive events are a radical new drug-device combination that relies on very sophisticated closed-loop in vivo monitoring, and the unexpected demographic shift resulting from greater life expectancy. With a disruptive drug-device combination successfully increasing life expectancy, the aging population would continue to increase, putting massive pressure on the healthcare reimbursement system and exerting significant downward pressure on the price of medical products.With such a large and growing elderly population, the Medicare system would require a radical overhaul.

Reviewing such a scenario, a medtech company in the patientmonitoring business might gain ideas about the types of technologies it should be working on in order to best position itself for the projected future. A company whose present-day monitoring technology is based on a relatively small number of vital signs and is used primarily in hospitals and clinical laboratories, for instance, might want to consider whether its market niche is likely to exist in the long term. As advances in microelectromechanical systems (MEMS), microelectronics, and sensor technologies act in concert to make subtle and less-invasive measurements possible for widespread home use, it seems likely that tests now performed infrequently in the lab could soon become noninvasive and frequent.  If the patient-monitoring company’s technologies and products do not already anticipate such a possibility, the company might want to consider gaining some firsthand experience with the relevant technologies in order to become better positioned for the future.

The illustrated scenario also suggests the continued inevitability of price pressure on the medtech industry.  Unlike the consumer electronics and automotive industries, the medtech industry has historically not responded readily to such routine pressure. The patient-monitoring company of this scenario might anticipate such long-wave-driven cost pressures by routinely leveraging broad technological advances to lower its costs progressively. A company’s prices may not need to fall as rapidly as its costs, but companies will be better prepared if they anticipate that the unexpected might force them to make dramatic pricing changes.

Given the rapidity of technical and social change in the wider world, managers of medtech companies can gain insight into potential disruptive events by asking what could destroy their business as well as what might grow it. Such issues might include technical, medical, or demographic trends, but they might also include competitive strategies and shifts in customer behavior.

In the case of the illustrated scenario, for instance, the patient-monitoring company might want to consider how the globalization of high-speed communications and the strong growth of knowledge-based service industries in the developing world might affect its business.  When data from a wireless personal monitor can elicit a real-time advisory from a healthcare professional viewing a computer screen in Delhi, for instance,what would be the effects on the company’s products and market presence?

Setting a Pace

It is always hard to act today on the basis of uncertain events tomorrow.  If a medical device manufacturer asks its customers what they want within the next 10 years, the manufacturer will receive notoriously bad advice.Customers are often not capable of envisioning scenarios that are radical departures from the way they have always done their jobs. As Kaplan notes, “Before they existed, how many consumers would have asked for Microsoft’s Office or an iPod, let alone a home defibrillator?  Today all these things are mainstream, and the organizations behind them have seen nothing but growth.”

In contrast, companies occasionally move on innovative ideas for which the market is not ready. The keyhole heart surgery system developed by Heartport Inc. failed to achieve widespread adoption because it was considerably ahead of its time.  Despite the fact that leading heart surgeons expect coronary artery bypass graft procedures to become less invasive in the future, the Heartport system did not meet market expectations when the company went public.

One way to tackle the difficult job of identifying winning technology opportunities is to approach these investments in a manner similar to the way the venture capital community proceeds once it identifies broad opportunity areas. Venture capital firms rarely try to pick a single winner; instead, they back several different players and technologies and meter their investments according to strict performance milestones. Successful venture capital firms reward an atmosphere that encourages taking risks. They nurture small, highly focused,multidisciplinary teams that can act fast but also respond quickly to changes in the wider world. However, they rarely back technology platforms that are looking for a problem to solve. Instead, they fund ideas that are focused on specific market needs—even if such needs are further on the horizon than those typically addressed by an established company.  Unfocused advanced technology research groups rarely lead to breakthrough products. In order to surf the big wave, medtech companies have to learn to ride the smaller ones first and be willing to fall off a few times before succeeding.


References
1.A Kleiner, “Carlota Perez: The Thought Leader Interview,” strategy+business magazine 41 (Winter 2005): 131–137; available from Internet: www.strategy-business.com/press/article/05410.
2. C Perez,Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages (Cheltenham, UK: Edward Elgar, 2002).

3. S Kaplan, “Discontinuous Innovation and the Growth Paradox,” Strategy & Leadership 27, 2 (March–April 1999): 16–21.