Medical device investing has been the “Steady Eddie” of venture capital; and also it’s Rodney Dangerfield. On Sand Hill Road, especially in the heady Internet days of the late 1990s, medical device entrepreneurs could hardly get a meeting, never mind respect. Many top-tier VCs either de-emphasized or completely shut the door on life science investing. Today, we realize that information technology (IT) and biotech valuations fall as fast as they rise, and those seasoned, rock-solid medical device entrepreneurs who’ve been waiting in the lobby are looking better by the day.
Steady Eddie indeed. While investments in IT are up 3.4% to $18.3 billion this year from $17.7 billion in 1998 (pre-bubble), dollars pumped into medical technology, equipment and services are up 42% to $1.7 billion during that same span of time, according to market researcher Thomson Venture Economics (publisher of Venture Capital Journal).
Mind you, the number of medical-related companies that received funding between Jan. 1 and Nov. 12 of this year totaled 254, down 25% from 338 in all of 1998. But VCs are putting much more money to work when they decide to make the deals. The average deal size soared 89% to $6.8 million this year compared to $3.6 million in ’98.
We at Charter are so bullish about med tech that our investment in the space has grown from 5-10% of our fund two years ago to a solid 20% today, and it remains a critical element of our portfolio and deal flow.
Unfortunately, for many top-tier early stage funds, the ability to potentially hit more singles and doubles with less volatility by investing in less-sexy medical device deals may be nothing more than a benchmark by which to compare IT deals.
Also, for a variety of reasons, medical device investing remains a difficult business for venture capital firms without previous experience to enter. First, the infrastructure necessary for successful investing takes time to put into place. This would include general partners who understand the area, sourcing solid deal flow and the ability of other partners in a firm to understand and contribute to the development of a medical device startup. Unless there is a long-term commitment to investing in medical devices, it is a losing proposition. The field simply cannot be handled by GPs who are stretching into the field. This isn’t a case, like Internet deals, where just about any GP can jump in.
The second challenge for venture firms is that one of the key advantages that deals in the device sector afford-capital efficiency-often isn’t a possibility for the majority of funds with excess capital under management. In fact, with a $1 billion fund, if you can’t invest at least $15 million to $20 million of your own money in a deal, it’s probably not even worth pursuing medical device investing.
Finally, unless firms are willing to own, monitor and mentor a hundred portfolio companies or more-the average firm usually seeks no more than 30 to 50 companies over the life of a fund-medical device investing simply doesn’t make sense.
Times Are a Changing
Yet, for specialized investors and smaller funds more focused on returns rather than capital deployed, the larger IT-centric funds’ loss could be their gain. Not only should there be less competition for deals, but shorter approval times for medical technologies by the Food and Drug Administration (FDA) may yield faster liquidity outcomes.
One of the reasons for the renewed interest in medical technology is that for firms with domain expertise and institutional contacts, it is a welcome hedge against the IT liquidity crisis. The old adage that the only way to overcome business cycles is to steadily invest through them has never been more true. This now applies to individual sector investing as well.
At Charter, for instance, we explicitly decided to stick with medical device investing in mid-2000, a time when IT was widely regarded as the best-returning category. Now, as Guy Nohra, a partner with Alta Partners, says: “The average upside profile for medical devices is the same as IT. We can raise $30 million and still sell a company for $170 million to $200 million.” As a result, it appears that our medical device portfolio will likely deliver a steady 3x return-average in terms of long-term venture returns but great when considering that returning any capital at all likely puts you in the top quartile of winning partnerships.
In an environment where VCs are searching for elusive exit opportunities, medical device companies remain in high demand as merger and acquisitions targets. Because there are relatively few large public medical device companies, there is intense competition between them to expand market share and product lines through acquisition.
“Little medical device companies are a highly efficient R&D source for these guys,” says Mike Laufer, a former partner with Menlo Ventures and the founder of more than four medical device startups. “The scientific, clinical and regulatory risks of acquiring these private companies are negligible, so only the market risk remains, and acquirers are comfortable with that,” Mike says.
NDO Surgical is a good example of how simple medical technologies combined with a bit of capital not only solve pressing medical problems but also offer investors the opportunity for strong returns down the road. The company, based in Mansfield, Mass., has raised less than $5 million from Charter and others, but even such a small amount of capital has allowed it to close significant corporate partnerships that are the first steps toward potential acquisitions.
For NDO, the issue was simple: how to cure heartburn. According to the company, more than 15 million Americans suffer from daily heartburn, the most common symptom of gastroesophageal reflux disease (GERD). Through NDO’s “Plicator” system, doctors can perform an outpatient procedure to restore the normal anti-reflux barrier to help prevent heartburn. If successful, the Plicator is the perfect type of medical technology larger device companies would find attractive.
Sometimes a medical device startup requires more capital than is typical, but that doesn’t necessarily mean a VC is heading down the wrong path. A good example is Cbyon Inc., a Mountain View, Calif.-based medical technology company that develops surgical software for spinal, neurological and ear, nose and throat surgeries. Using Cbyon’s software, CT and MRI scans could be used to construct a virtual patient from a physical patient, allowing surgeons to eliminate much of the guesswork from what they previously could not see. Incisions could be smaller, surgeries less invasive and procedures less costly for patients and hospitals alike.
Alloy Ventures and Bedrock Capital joined Charter in putting the first $5 million into the company. Just two years later (after three rounds totaling $30 million), Cbyon is shipping product and has 35 installed users, including prestigious hospitals Cedars Sinai, Massachusetts General and Stanford University Hospital. In that context, $30 million isn’t a terribly large investment.
The medical technology market is, admittedly, not without its own set of challenges. The first is barriers to entry. Dr. Donald C. Harrison, senior vice president and provost for Health Affairs at the University of Cincinnati Medical Center (and former president of the American Heart Association), has seen dozens of these deals. He has also founded several medical device companies. “In biotech, a company can be based on an observation made in a lab, which might be hard to duplicate,” he says. “With medical devices, though we’ve already identified the market, the risk is that someone could come along and invent a better mousetrap.”
A second challenge is that medical device companies often require proven earnings before they are acquired, requiring investors and entrepreneurs to stick with companies into farther stages of maturity. By comparison, biotech companies, despite a greater investment of time and money on the part of VCs, can often exit while still in pre-earnings, if not the pre-revenue, clinical phase.
In a sense it comes down to the law of large vs. small numbers. If VCs need bigger returns to satisfy the requirements of bigger funds, they must take bigger swings of the bat, as is typically the case with biotech and other life science deals.
By comparison, medical device companies are the singles and doubles of our field, producing modest returns but requiring less capital and less risk. And, as former Menlo Ventures partner Mike Laufer points out: “If VCs can help medical device companies decrease the cost of care, there will always be an opportunity to make money here-always.”
Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. He specializes in enterprise software, software infrastructure, e-business and wireless technologies and sits on the boards of Ellie Mae, ManageStar, Quantum3D, Talaris, Verano, Winery Exchange and Xavient Technologies. Email him at