Medical Device Link.

Originally Published MX May/June 2003

FINANCE

Outsourcing company capabilities offers a viable strategy for advancing company objectives—and increasing company valuations—in tough economic times.

Stacey L. Bell

Start-up medtech companies are known for their great product innovations, so it shouldn't be surprising that smaller companies are applying that innovation to their business models as well. After all, the availability of venture capital isn't what it used to be during the go-go 1990s.

In 2002, 542 privately held biotechnology, pharmaceutical, medical device, and other healthcare companies raised $6.3 billion in venture capital, according to Growthink Research (Venice, CA).¹ Those figures reflect a slight decline from 2001, when 610 healthcare companies raised $7.1 billion. However, the 2002 healthcare companies snagged 25.7% of the total venture dollars invested nationwide compared with 15.8% in 2001, demonstrating that investors are still interested in the sector even though fewer dollars are being committed (see Table I).

A Challenging Investment Climate

"It is a very challenging time for any company that is currently seeking to raise venture capital," says Corey Lavinsky, president of Growthink Research. "Venture capital funds are getting smaller, and several corporate investors have slowed or stopped their investment activities. Funding for the medtech sector will continue to decline in 2003 due to fewer investments made by fewer investors and the current global unrest that will affect all sectors of the venture capital industry."

"The economic environment for small companies is difficult, with tremendous pressure on valuations and difficulty in raising funds," agrees Ilya Nykin, managing director of Prolog Ventures LLC (St. Louis). "There's more scrutiny now, and funding decisions take longer."

What's a small medtech company to do? In tough economic times, more companies search for ways to conserve cash so that they can build company value and hold on until the IPO market resurges, until they can generate substantial revenues themselves, or until another, larger medtech company seeks to buy the firm. Outsourcing company capabilities can fill the bill for each of these goals.

Lavinsky, who's studied small medtech companies and their funding for about a decade, says "the outsourcing model is really the intelligent way to go because you're outsourcing activities to experienced companies that have been down this road before."

The outsourcing model does have benefits, concurs Nykin. Outsourcing provides the flexibility necessary for a company to modulate its activities, control its burn rate, and stop and start projects quickly. But there is a downside.

"It's a question of degrees," Nykin explains. "Either extreme is not an attractive proposition. If a company is doing everything itself, there are obviously areas that could probably be done better by someone else. If a company is outsourcing everything, it doesn't have as much to offer. We're not investing in someone's proficiency in procurement logistics. The company must have a core, value-generating expertise in-house."

As an example, Nykin says a company should not outsource its key intellectual property (IP) development activities, but finding a university researcher that specializes in a particular disease to perform animal tests would be very cost-effective.

Manufacturing can be done by others, but product development should be kept in-house, adds Brenda Gavin, managing partner of Quaker Bio Ventures (Philadelphia). "Outsourcing isn't always cheaper," Gavin says. "To hire a good statistician to conduct one study can cost $100,000. If you're running five studies, it's much cheaper to hire a full-time employee at a $100,000 salary. Likewise, I know of many smaller companies that have their own internal lawyer. It seems inefficient, but young companies have so much legal work.

"Starting out as a virtual company can be a wise thing to do, but you can't make progress unless you have certain functions under your own control—for example, R&D and product development," Gavin concludes.

MX recently spoke with three companies that have taken the "virtual" route in an attempt to reach their goals.

Focus on Strengths

Smaller companies choose to outsource for numerous reasons. Outsourcing often proves more cost-effective than purchasing or building office and manufacturing space, laboratories and cleanrooms; buying equipment; and hiring an extensive staff. And it provides flexibility, speed, and control over one's business and destiny.

Joan Cory, PhD, CEO of CKM Diagnostics Inc. (Bozeman, MT).

CKM Diagnostics Inc. (Bozeman, MT) considered all of these factors when creating its business model. The company was founded about 10 years ago to develop a new nerve-imaging technology. For the first eight years of its existence, everyone associated with the company had an outside job and worked at CKM on the side. In 2001, two employees went full-time: CEO Joan Cory, PhD, and a director of R&D.

While the company was initially funded by its founders and then by a round of financing from small, private investors, CKM Diagnostics is currently preparing for its first, large investment round to fund commercial prototyping, clinical trials, and regulatory submission.

"To this point, we've had limited resources—and have chosen to work with limited resources—in part so that we don't give up control of the company and the technology before we have it fully developed," Cory says. "Our current business model does have us outsourcing quite a bit so that we can focus on our strengths—inventing, developing, and testing. We've identified what we're good at, and we're outsourcing much of the rest, at least initially. We want to build maximum value in the company, and we need to do so without spending maximum resources. Outsourcing lets us do that."

The company has scrimped on office space and equipment purchases in order to devote capital to hiring contractors to assist with IP protection; to perform market analysis, financial planning and accounting, legal work, and commercial prototyping; and to devise strategies for regulatory and reimbursement issues. Outsourcers are paid in cash and, in some cases, are provided with some equity in the company. About a dozen firms have worked on CKM projects.

"By hiring experts in these areas, we can focus our time and energy on our core IP with few distractions," Cory explains.

Other benefits also accrue. In running the numbers, CKM Diagnostics has found that by outsourcing these functions, it has spent less than one-fourth what it would have cost to hire full-time experts in each area. Further, the company has been able to hire nationally known, top talent, even though the company isn't based in a technology hotbed.

"We're located in a rural state, and while Bozeman has a growing high-technology sector, we clearly needed to go nationwide to obtain expertise in certain areas," Cory says.

And by contracting with some of the best firms in the industry, the company is reaping an additional return on investment. "Eventually we will want to bring some of that expertise in-house, so we're basically buying an education from the top people in each field, and we'll then incorporate that knowledge into our business later," Cory notes. Further, in building relationships with well-known companies throughout the medical device industry, CKM Diagnostics is also building a reputation for itself and developing valuable contacts.

"In the end, these relationships may very well help us find a buyer," Cory says. "By working with top firms, we're creating greater value in our company and creating investor confidence. Our financial advisers say we're nearly ready for our first big round of investment, and outsourcing has been an efficient, flexible way for our company to grow to this point, even with limited resources."

Faster Results

Figure 1. The CathEffects Desai VectorCath Mapping Catheter was brought to market in just 16 months by virtual device company CathEffects LLC (Roseville, CA).

In 16 months, with just two full-time employees, CathEffects (Roseville, CA) froze catheter and software designs, manufactured test lots, passed FDA and CE mark testing, gained FDA and CE mark clearance, gathered 100-plus leads at major industry trade shows, and launched a product for clinical use in the United States and Europe (see Figure 1). How was CathEffects able to accomplish so much in so little time? COO Shawn Fojtik credits a dedicated outsourcing team.

Fojtik says, "When CathEffects was founded in October 1999, we decided to use this business model because it provides speed, simultaneity, and flexibility with little capitalization," an important consideration since the company was, and remains, privately funded. "Our goal is to build this business up to be profitable and self-sustaining, and then we have choices."

The company outsourced initial R&D, manufacturing, legal, accounting, packaging, and sterilization activities. "No matter how big a company is, everyone is doing some outsourcing," Fojtik says. "At least a dozen components of our catheter would have to be outsourced regardless of our business model. It's not a question of do you outsource, but rather how much and when. There aren't any ifs, ands, or buts about it: if we hadn't outsourced, we'd still be months away from having a viable product. We brought our product to market faster, with less overhead, by being a virtual company."

Still, the road wasn't without potholes. One contract manufacturer kept missing deadlines for product changes due to an internal restructuring. After a few delays, CathEffects pulled the plug on the contract and moved the project to another company. The initial contract manufacturer did reimburse CathEffects for some engineering time, but it wasn't feasible to claim lost time-to-market.

Jawahar M. Desai, MD, founder (left), and Shawn P. Fojtik, president, of CathEffects LLC (Roseville, CA).

"One of the benefits of outsourcing is that it's theoretically easy to move to another company if you're unhappy. But you do have to stay on top of what they're doing," Fojtik notes.

In addition, outsourcing manufacturing can and will increase the cost of goods sold and decrease gross margin, says Fojtik, since the contractor is building a profit into the price being charged. Of course, the alternative is to sink hundreds of thousands of dollars into equipment and facilities, which is obviously not an option for small start-ups.

Fojtik also warns that companies that outsource "relinquish some control of their fate and their product since it's not your people turning the screws or doing the drawings. You may not control the quality systems since the company has its own system that must meet the needs of numerous clients, and you don't handle their hiring processes.

"There are also unwind risks," Fojtik continues. "If you're hoping to be bought by a larger company, but your catheter requires a special fixture that belongs to the outsourcers, it can affect any potential sale."

Therefore, finding a stellar contracts attorney is paramount. Not only do smaller companies want to have an escape clause that lets them exit a relationship that is not meeting established quality and timeline benchmarks, they need to protect their IP and future. "The number-one concern is to make sure you own all of the processes that you contract for," Fojtik emphasizes. "Protect your intellectual property. Every design history file, every prototype, every design review, every manufacturing instruction, and every fixture needs to be owned by the company that contracts the work."

Going Virtual for Good

Russ Houser, president and CEO of Advanced Catheter Engineering Inc. (Livermore, CA), is concerned not only with protecting his company's intellectual property, but also with protecting its future.

Figure 2. Developmental illustration of a tissue stabilizer for beating-heart surgery, now being developed by Advanced Catheter Engineering Inc. (Livermore, CA). A patent on the product is pending.

In the late 1990s, Houser founded Converge Medical, which started as a virtual company, raised $400,000 in a Series A funding round, and then landed $3.6 million in a Series B venture capital round after functional prototypes were developed. Houser found that he had to give up a lot of control of the company to win VC financing.

"In the first round of VC financing, it's not unusual for the VC to stack the board of directors in their favor, so they have a quorum without you and own the majority of stock," Houser says. "In some cases, there can also be conflicts of interest. Your company may be doing reasonably well; however, the VC may still merge your company with another one of its portfolio companies, whether or not you agree. Certainly, a lot of good companies and products wouldn't be around without the help of VCs, but with my new company, I wanted to maintain more control and flexibility. So our business model is a little different. We're developing virtual products within a virtual company, and our goal is to stay independent."

So far, so good. Advanced Catheter Engineering has sold or licensed several products to other companies. The company typically develops products for cardiac surgery and interventional cardiology (see Figures 2 and 3).

Houser is the only full-time employee. He engages as needed a designer or drafter, IP lawyer, contracts and business attorney, CFO, contract manufacturers, machine shops, quality systems consultants, sterilization vendor, preclinical testing facility, and a commercialization and distribution company.

"We focus on going from zero to proof of concept, and then I shop the technology around to various business development contacts from large medical device companies, or I raise a small amount of money to get the project through the regulatory process," Houser explains. "These are usually 6- to 9-month projects, which I focus on because the value curve of a product never increases so much as when you're going from zero to creating solid IP and providing proof of concept with in vitro and in vivo testing using functional prototypes."

Figure 3. Developmental illustration of a rapid exchange balloon catheter being developed by Advanced Catheter Engineering Inc. (Livermore, CA). A patent on the product is pending.

Houser notes that his projects typically have three potential exit points. "First is when you have a strong enough IP, but that time has the lowest value," Houser says. "Second is when you have IP and proof of concept in vitro on a benchtop model. To go from zero to this stage costs us about one-sixth of what other companies with in-house operations spend because we have little or no learning curve, no building, no staff. We're increasing the value of the project by 25% and in some cases by as much as 50% or more during each phase of the project by using outsourcing. The third milestone is regulatory approval. Obtaining regulatory approval typically costs twice as much as product development because of the preclinical studies, but once you get to this level, investors and potential acquiring companies will beat a pathway to your door. They like proven products, so you don't have to worry about raising money after you get to this point."

Houser disagrees with VC claims that outsourcing can cost more than in-house help. "It would be unwise for a small company to hire a full-time in-house lawyer," he says. "When you're first forming a company, clearly you need a lot of legal work in setting up the corporation and such. However, going forward, do you really need to pay $250,000 a year to have a full-time attorney—one who, by the way, may not have expertise in other areas such as IP, contracts, litigation for patent infringement, reimbursement, and the many other legal areas that your company may face? That costs more than double what it would to pay a hotshot engineer with 10-plus years of experience. It's just not a justified expense for a small company.

"Plus, [for many positions] you sacrifice some broader expertise and experience when you hire one person rather than a firm," Houser continues. "Certainly consultants cost a premium, but in exchange you're paying for just a fraction of their time and getting all of their competency, knowledge, experience, and speed."

He points out that the current economy has also affected outsourcers. Many aren't operating at full capacity, so they're more willing to work with smaller companies at lower rates than they might have charged in the past.

A Viable Future

In the long run—and particularly in tough economic times—Houser believes the virtual company strategy will become an even more popular option for smaller companies. Indeed, when he explains his business model to investment bankers, many wonder why more companies aren't already operating in a similar vein.

"It's no longer reasonable to have a traditional company go through $20 million or more in two years and still not have 510(k) regulatory approval," he says. "Some companies still burn through all that and more and have little to show for it but a building and staff. With a virtual company, because you have the experts in place, you can get a 510(k) much more efficiently—saving time and money. That's the best situation for everyone involved—company owners, investors, and patients."

Reference

1. Healthcare Venture Capital Report: 2003 Annual (Venice, CA: Growthink Research, 2003).

Stacey L. Bell is a freelance writer who specializes in business and marketing issues. She is based in Tampa, FL.

Copyright ©2003 MX