Originally Published MX March/April 2003
FINANCE
Financing for MedtechEven in today's tough funding environment, companies with the right blend of focus and execution can still attract significant investment dollars.
Moderated by Steve Halasey
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Sidebar: |
Medtech executives don't have to look far beyond their own doors to discover that today's economy is suffering on a global scale. Although private investment in medical technology companies has managed to hold its own—and perhaps even to gain a bit—relative to investment in other industries, some indicators tell a less encouraging story.
In the world of private medtech investments, overall funding and company valuations have declined considerably since 2000. And in the public markets, the opportunities for successful initial public offerings (IPOs) have been virtually nonexistent since 2001.
It's no surprise, then, that the leaders of many start-up medtech companies are finding themselves wondering what happens to a good idea that goes unfunded, or to a growing company that, in the parlance of market analysts, can't get traction in today's economy.
To find out more about how medtech company leaders are coping with today's funding environment—and what strategies they can apply to anticipate future needs—MX spoke with six experts in the field (see sidebar).
MX: For many device companies, these are pretty hard financial times. During the second half of 2002, venture capitalists invested just a little over $690 million in medtech companies. Is that puddle of investment enough to support entrepreneurial companies in the industry?
Keith Brauer: That $690 million is certainly down from what it was in some of the stock market heydays, particularly in this area. So for that reason I'd say probably no, it's not enough.
Obviously, Guidant is a company that lives on innovation, with two-thirds of our sales in any one year coming from new products. Every one of the companies we have acquired got its start through innovation. Advances in medical technology come from such start-ups, and venture funding is crucial to their existence.
So having venture funding dry up is something that we don't like to see, because it prevents innovative ideas and opportunities from coming to fruition.
Michael Heller: From my perspective as a lawyer representing a lot of early-stage companies, it seems that the pipeline for seed-stage and series-A funding has become especially dry. As a result, there's a lot of R&D that's not being funded right now. Until those funding levels are increased, we're going to have a tough time with early-stage companies.
Lars Enstrom: The data we have show a decrease in total private equity funding for healthcare ventures throughout 2002, and certainly the medical device sector has taken its share of the decrease. The data also show an increase in mergers and acquisitions (M&A), as the unavailability of funding is driving many early-stage companies to the M&A market.
Sami Hamade: The total money raised by device companies has certainly been declining. In 2000, medtech companies raised about $2.5 billion, whereas the total for 2002 is running around $1.4 billion. I would agree that that's certainly not enough.
But the companies that are starving occupy both ends of the spectrum. Seed money has certainly dried up but, quite honestly, mezzanine funding has dried up a lot, too. Medtech companies have a long pull to go through, and a lot of requirements to meet, and they require a lot of cash to sustain their progress.
Most venture capital (VC) funds are interested primarily in early-stage companies because that's how they can get their return on investment and their cash-on-cash returns. Very few such funds are investing on the late-stage side. In recent quarters, there hasn't been much money available for taking a medical device company from a C or D round to what could potentially be an acquisition or an initial public offering (IPO)—if there is such a thing these days as an IPO.
Nicola Young: To provide a counterpoint, however, not all businesses nor all venture capitalists are created equal. A herd mentality can complicate funding prospects in both good times and bad, but big ideas and transforming technologies get funded via fundamentals-driven investors regardless of what the herd is doing. Those types of ventures will still attract financing in a tough market.
In the past 18 months, for example, Stereotaxis has raised $50 million in venture funding. And we have been able to do so at a step up each time, so that we're now at a valuation of $150 million.
The current environment is one in which investors' scrutiny of companies is greatly increased. But if a company can demonstrate that it has a crucial role to play in its sector, the market will recognize that.
Craig Carlson: The experience of Cygnus with early-stage venture funding is 15 or 20 years old, but I agree that there is venture money out there if the ideas are good. What's happening now, however, is that the definition of what constitutes a good idea is becoming tighter and tighter, and therefore the money is being focused on a smaller number of potential opportunities. Fringe opportunities are not getting funded.
There is also money available for public companies such as Cygnus, but unfortunately the nature of that money is sometimes not what a medtech company wants. Cygnus is one of many companies that have moved from NASDAQ down to the OTC Bulletin Board. As soon as that step took place, I had probably a couple of dozen calls from people who had a lot of money for our needs. Many such investors don't care at all about the fundamentals of the company, and they're only investing to make their profit. I understand their motive, but I always get scared when someone is willing to invest a lot of money and knows nothing about the company.
Risk and Due Diligence
What do investors in the medtech industries know about the companies they are investing in and what do they need to know?
Carlson: One experience of Cygnus is a good illustration. A number of years ago, the company's former management got the company into a toxic convert. When new management came in we wanted to get rid of that, so we entertained proposals from some private investors for that purpose. We had proposals from half a dozen investors who were not even remotely interested in performing due diligence on the company and were still going to offer certain products. But the one we eventually selected came in and did a serious amount of due diligence.
The better sort of investors do their due diligence. It's best to steer clear of the others, because in most cases they're not in the best interest of the company's shareholders.
Hamade: In our circles, we haven't seen a lot of investors who are willing to just wing it with regard to due diligence. Over the past two years, we've seen increased scrutiny—not less scrutiny.
We and others in the venture capital community—whether they are traditional VCs or corporate venture capital people like us—are really scrutinizing companies and declining investments in highly risky endeavors. To minimize the financial risks of such investments, in fact, valuations are being driven way down. And this is even true in cases where intense due diligence has demonstrated the solidity of the company in question.
What are the risk factors of greatest importance to investors in early-stage medtech companies?
Hamade: The classic items reviewed during a due diligence process include things like intellectual property (IP), market gross, market size, the track record of the management team, the potential and ability of the management team to steer the company in different directions if it encounters obstacles, and exit valuations.
In this period, the window for IPOs is more or less closed, and most medical device companies are experiencing a relatively low ceiling in terms of acquisition value. Medtech acquirers have become very sensitive to the money valuations of the companies they acquire, pressing them down so that they can guarantee some sort of a return. Acquirers are also insisting on liquidation preferences and other full ratchets that guarantee a minimum return on investment if the company experiences any success whatsoever, big or small.
Another risk that pops to mind is the unpredictability of the processes followed by both FDA and the Centers for Medicare and Medicaid Services (CMS). In its annual reports and other public forums, Guidant has repeatedly explained that such public policies constitute the single biggest risk that we as a corporation, or as a venture capital group of a corporation, and traditional VCs must grapple with. Companies have become accustomed to managing the usual risks of management and market potential, but the uncertainties that envelope approval and reimbursement need to be dealt with in a broader public policy context that protects innovation.
Brauer: The risk is a public policy concern, but it also has investment implications. For instance, FDA has increased its submission requirements for more and more products in the direction of treating them like premarket approval (PMA) applications. And as that has happened, we have noticed a lot of investors backing away from funding medtech products unless they can see something quicker coming along or a little more certain route.
Hamade: Absolutely. So, in addition to the disappearance of seed money and mezzanine round funding, you can include the disappearance of funding for anything that is likely to require a PMA. It doesn't affect our investments much, but a lot of traditional venture capital folks are having huge heartburn over investing in anything that isn't likely to provide a return on investment within two to three years.
How well do today's investors handle such risks?
Young: The VCs who can best tolerate risk are those who really understand the market they're investing in. It sounds obvious, but I don't think that today's investors are learning about industries through due diligence. Instead, they're learning about a company in an industry that they already understand; otherwise, they're staying away. The herd is on the sidelines.
Investors who are able to step forward are those who have confidence in and knowledge of a particular industry area, and who are able to do the analysis of a company's fundamentals. These investors who really understand the sector a company is in—in our case, the cardiac catheterization lab—tend to be somewhat more thorough in their due diligence. They are focused on the relevant points rather than on just generating a paper trail.
Heller: Here in the mid-Atlantic region during the boom, a lot of venture funds invested in multiple industries solely to diversify their portfolios. In many cases, those industries were outside the funds' core expertise. Venture funds have learned their lesson and are returning to investments in technologies they know and understand.
At least in this region, there are not a lot of venture funds that focus primarily on the medical device field. And that's really hurting a lot of the early-stage companies that are looking for capital. There is grant money out there, but it's focused mainly on R&D. That kind of funding doesn't really enable companies to expand their infrastructure, develop a sales and marketing team, and so on.
So I think it's true that the sources of early-stage funding have been reduced to those funds with the necessary knowledge, and that they are investing only in those companies for which they have significant background and experience.
Enstrom: I agree. A lot of the people who were on the bubble—that is, the non-healthcare-specific investors—are now out of the field entirely. Unfortunately, that trend has also cleared out a lot of the crossover, late-stage funds. Many of those folks were not healthcare-specific investors, so their disappearance has drained away some of the capital that might otherwise have gone to late-stage medical device companies.
All of this comes back to the proposition that there is a dearth of money. The funding that is available now resides solely with seasoned healthcare venture capitalists and no longer with diversified venture capital companies.
Are investors generally that technology specific? Is it a key requirement for investors to pay particular attention to a field that they think has promise, such as cardiology, orthopedics, or genomics?
Heller: Yes, but I think investors are returning to fields that they know, areas in which they have background knowledge and experience. The real sophisticated investors are going back to what they know best.
Brauer: The projections for some fields offer pretty clear indicators that those are where the best market opportunities lie. It's probably also the case that those are fields from which investors can get a good exit.
In other words, if there's early money being invested in a particular field, there are probably more players invested in that field. Ultimately, that means that a company with a good IP, a good idea, and a good technology has a better chance of locating players willing to invest in them or take them out at some point in time.
Young: Companies have to bring a defensible IP position in a transforming technology that addresses a major market. Nondefensible technologies and "me-to" or niche products are probably not having a good time in the financial markets today. For investors, identifying defensible value creation in some form of transforming technology takes industry expertise and the confidence that goes with it.
Are there particular sectors of the device industry that are considered fringe areas, and are therefore less likely to get funding? What are the funding options for companies in those fields where there is little investor interest?
Enstrom: That's clearly a very difficult situation. A good example is the ventricular assist field, where there was initially a groundswell of investment interest simply because the indicated use of such devices suggested that there would be significant expansion in the market. However, that interest has in large measure given way to despair, partly because of the extraordinarily long timelines required for regulatory approval. Some companies in that field are being funded, albeit at a much slower pace. Some companies have managed to get funding from foreign, principally European, venture funds, but the mainstream U.S. VCs are not necessarily involved.
Outside of the big areas of interest—neurology, cardiology, and orthopedics, for instance—it's been difficult for companies whose areas are not at the forefront of investors' minds.
It sounds as though company executives must remain very flexible if they are to make some of these private equity options work. Is that an accurate assessment of today's conditions?
Heller: With regard to the specific terms of funding deals, that trend isn't just associated with the medical device field; it's all over the venture capital community. A few years ago companies might have had some leverage in negotiating venture capital transactions, because there were multiple funds competing for the same investment. But those times have changed.
Today, if a company really wants and needs capital, it is likely to be looking at some very harsh terms. Full-ratchet antidilution protection, multiple liquidation preferences, and very low valuations are the norm these days.
Young: While that is generally true, I still think that a big idea in a transforming story can do well in this market.
A market like this is very, very tough unless you have a crucial role to play in the industry you're addressing. We believe we have a crucial role to play in the cardiac cath lab. The market has given us credit for that and we've been able to put in place each of the elements required to prove out that story over the next couple of years. Unless a company has a very clear and compelling value story, that type of favorable financing valuation is not possible.
Hamade: Yes. Truly disruptive or potentially disruptive technologies still have a great shot at success. I can count them on one hand, but in the past year there were two or three such offerings here in Silicon Valley that were oversubscribed. Great ideas that could be greatly disruptive, or defensible ideas that create incredibly new opportunities, are still being oversubscribed. But it takes a lot more to leap over that hurdle.
Investors have traditionally expected companies to meet certain milestones—such as the completion of clinical trials or FDA approval—and then go on to their next round of funding. In this environment, do the old milestones still apply? How comparable are the valuations related to those milestones?
Hamade: In the past three years, the average for third-round, premoney valuations has dropped significantly. Where they used to average somewhere north of $35 million—maybe even $40 million—they're now down to $10 million or $15 million.
So valuations have certainly gone down. In part, this is a sign of the times. It's a sign of the fact that the IPO window is relatively closed, and that most company exits are taking place through large-company acquisitions of start-up companies.
With regard to the relationship between milestones and funding, what we are seeing is that companies with great promise are going for much larger amounts of money to take them to the finish line. That finish line can be defined in various ways, but more often than not it's through the completion of clinical trials and at low valuations—which means a lot more dilution to the management of start-ups. But we've recently seen larger and larger rounds in absolute dollar terms.
Heller: I'm seeing the same exact thing. The milestones are the same, but the scrutiny is much tighter. Hitting one or two milestones is not enough anymore—companies have to hit multiple milestones.
What can the leaders of start-up companies do to improve their chances of making a good deal with a potential acquirer? What caveats should be applied to those deals?
Young: Companies have to ensure that they are bringing value to the table.
Brauer: Yes. Companies have to execute on their strategies. And they should also conduct their own rigorous due diligence to review what they are bringing to the table, because they can certainly expect that big companies will do the same.
Hamade: Start-up companies have to know who they're dealing with. Not all corporations are necessarily created equal in terms of their philosophy, and they don't all provide the same value to their junior partners.
Since the late 1980s, start-up companies have been somewhat fearful of dealing with corporations. And quite honestly, when the IPO window was open, in a lot of cases they didn't need to do so.
But whether the IPO window is open or closed, there can be tremendous value to partnering with the right corporation. The goal is to create enough value in the entity so that it can either go through an IPO or get acquired. In either case, corporations have a lot to contribute to that effort.
Just how big is the war chest available to large companies? With the IPO window closed, at least temporarily, how much investment and acquisition can such companies support?
Brauer: In terms of investing, we're not going to pass up a good idea. We have employed a variety of creative methods for supporting the development of early-stage technologies, including investments, loans, licenses, and milestone payments.
Some of our investments are made so that we can learn more about a technology, and some are made to enable a technology to prove itself out a little bit longer. And although such investments might be considered high-risk ventures, they also share with the rest of the medtech industry the potential for some good returns.
A lot of the bigger companies, like ours, have strong cash flows and are able to do these kinds of things besides funding our own R&D.
Heller: Public company buyers are using stock as a consideration. Their cash is being put directly into the R&D and infrastructure development for the technology that they are acquiring.
In many cases, the process of acquisition is driven by the venture funds that have put money into the early-stage companies that are being acquired. They have multiple reasons for selling, not the least of which is that they need to show their limited partners some sort of return. In some cases they are driving the acquisition process so that they can exchange their private company stock for public company stock—not necessarily based on valuations.
Conclusion
What can emerging medtech companies do to position themselves to gain funding in the short and long term? What should large-company executives be watching for over the remainder of this year?
Enstrom: Ideally, start-up medtech companies need to make sure that they're in a distinctive market segment with a really revolutionary, market-leading product. Other things that company executives have to do include managing their ventures like a business—making sure that their burn rate is low, that they conserve capital, and that they devote their resources to achieving the most important FDA and time-to-market milestones. In short, start-up executives need to develop their companies in such a way that they can actually become businesses.
Heller: Venture funds are focusing very heavily on management and management experience. Consequently, entrepreneurs who do not have a lot of experience at running businesses would be well advised to surround themselves with others who do have such experience. The better the people they put around themselves, the better their position will be to receive funding.
Brauer: I think Lars spoke very well. Big companies will be looking for exactly the points that he mentioned: making those milestones and making sure that the company does things right with FDA. And, of course, intellectual property pieces are key. Anything that makes a company proprietary in this regard is something that we'll be looking for.
Carlson: Companies need to understand the market they're in, make sure that they have a competitive difference in the form of IP, and stay very, very, very focused on conserving cash during the early days.
Start-up companies have a tendency to put more bells and whistles on a basic technology and go forth too early. That's a sure method for spending a company down a lot of blind alleyways. Companies should stick to their knitting, as they say.
Young: I think it's important for companies to focus on addressing existing or clearly identifiable markets in a transforming way. I don't think there's a great appetite out there for missionary selling potential markets.
Hamade: If a company doesn't have a business model that works, then it's a nonstarter. A start-up company that doesn't have a plan to get reimbursement is going to make other companies very reluctant to invest in the start-up venture.
In the grander scheme, the macro elements that could affect innovation certainly include the public policies of FDA and CMS. The more certainty we have about what FDA considers safe and effective and what CMS considers reasonable and necessary, the better off we would all be.
Copyright ©2003 MX
A Defensible Position
Harsh Terms
Getting to 'Deal'
