Just what the doctor ordered

Asked to name the hottest investment category in Silicon Valley, most people would reasonably guess it was Web 2.0, cleantech or open source software.

In fact, medical device and equipment companies pulled in more money than any other kind of company in the first quarter of this year in the San Francisco Bay Area, the epicenter of the technology universe. They raised $447 million, or 21% of the total investment in the region, eclipsing the software segment, which traditionally holds the top spot, according to the MoneyTree Survey.

What’s happening in the Valley mirrors a national trend. Medical device investments hit their highest point in the past five years in Q1 and Q2 of this year based on the total amount invested as well as the number of companies backed (see chart).

“There is more money in medical devices than maybe at any time before,” says Ross Jaffe, managing partner at Versant Ventures and one of the most experienced investors in the sector.

Why? Part of the reason is that more money is flowing into the health sector. “The Internet was a distraction,” says John Maroney, general partner at Delphi Ventures. “It pulled a lot of attention away from health care. But now we’re seeing a rebirth of the health care market—and we’re seeing attractive outcomes. That, more than anything, attracts investors to this space—the visibility of exits, either via IPO or M&A.”

Of the 54 venture-backed companies that have gone public this year, six are medical device makers (see table). Of that group, five are trading higher than their offering prices, with an average gain of 16% from their IPO price to Aug. 13.

Another reason why devices are popular now is recent difficulties in the biotech and pharmaceuticals sectors. A few high-profile drug disasters, such as the Vioxx litigation, have spurred a tougher review process at the Food and Drug Administration.

“Medical device businesses are more solid in their plotting of progress and achievement,” says Robin Bellas, a partner at Morgenthaler Ventures. “You know how the FDA will react at each stage so you have a pretty methodical business plan that you can count on.”

Devices are also easier to test than drugs because they tend to work in animals much the same as they do in humans.

The Internet was a distraction. Now we’re seeing a rebirth of the health care market — and we’re seeing attractive outcomes.”

John Maroney, General Partner, Delphi Ventures

In the past, getting a medical device startup from start to acquisition required a total investment of about $25 million. However, getting the company from start to IPO typically requires about $40 million to $60 million, according to Simon, which is more than he or his firm (Clarus) is willing to commitment.

This dilemma has caused some venture firms, such as Clarus, to shy away from early stage medical device opportunities and focus instead on later stage investments. By taking this approach, Clarus believes it can eliminate any technical risk from the equation and instead just concern itself with the execution risks and market adoption.

“Our priorities have clearly changed in terms of our risk arbitrage,” Simon admits. “In early stage investing you have to get comfortable with the technical risks, such as getting the product to work and then getting regulatory approval. With late stage investing you come in once those issues have been resolved. Instead you concern yourself with other risks, like building the right team and getting acceptance in the marketplace.”

Of course, this does not bode well for early stage medical device companies, which are finding it harder to attract funding. Alex Tilson, founder of Loma Vista Medical, spent several months looking for VC funding. The company, which is 1 ½ years old, is working on a next-generation device that can reduce the expense and discomfort associated with a colonoscopy.

“The threshold for investment is quite high these days,” says Tilson. “Many VCs are reluctant to take on the technical and clinical risks.” Instead Tilson has set his sights on finding a corporate partner that can assume many of his business responsibilities, such as taking the product to market once it’s ready, while Tilson and his team of contractors work on the technical issues.

“There is a long maturation period for device companies,” says Morgenthaler’s Bellas. But once they’ve matured, they are solid investments. “We now have medical device companies that have achieved reimbursement from both the private insurance companies and Medicare and that have cleared regulatory hurdles at the FDA,” Bellas says. “They have data on the marketplace that indicate their devices really do well.”

Investment in later rounds has never been higher, and valuations are soaring. “Recently we’ve seen a number of device companies in our portfolio get later stage rounds done north of $125 million pre-money,” Jaffe says. “That’s something I’ve never witnessed before.”

He cites Acclarent, which is pioneering a novel approach to sinus surgery. The company raised $35 million in third round founding, led by Meritech Capital Partners. “Another thing we’re seeing for the first time is nontraditional players like hedge funds and crossover investors coming into the market,” Jaffe adds.

There are other discouraging trends that could slow investment in the medical device market. For one, it’s getting harder for patients who opt for new medical devices to get reimbursed by their insurers, Jaffe says. “By far the biggest challenge is getting reimbursement for new products,” he notes. “It’s also a question of whether insurers will recognize your device or procedure. And then is it something they’ll cover at an adequate enough level so that patients will actually adopt it? As our health care system approaches the crisis point, there is increasing scrutiny on new technologies. This makes things difficult for everyone.”

There is a big movement among 20- and 30-somethings to pursue these cosmetic options. We’ve had a very robust economy, so people can afford to pay for these procedures out of pocket.”

Nick Simon, Managing Director, Clarus Ventures

Purely cosmetic

Some VCs are avoiding the problem by investing in devices that they know people will pay for out of pocket, such as those designed for cosmetic applications.

One recent investment that fits this model is Sientra, a maker of silicon breast implants that raised $85 million from a consortium of investors that included Clarus. The company’s product is selling well in countries such as Brazil. The goal is eventually to introduce the product to the United States, which is the world’s largest market for breast implants at roughly $1 billion annually.

“We will be the third entrant in the U.S. market, but there are some advantages to this product in terms of aesthetics and safety,” Simon says. “From our perspective, this is a pure commercialization and execution play.”

In some cases, companies that make devices with cosmetic applications require less capital. Juniper Medical, for example, makes a liposuction product that is noninvasive, so it is expected to get to market faster than it would if its device were invasive. “With Juniper, we envision a relatively short development period so we’re going to fund it through commercialization,” says Every. “We actually have several companies within that model. I think a lot of health care VCs are thinking about this. Either you need to invest later or you need to think about accelerating.”

Another plus for cosmetic medical devices: a growing market of consumer with deep pockets. “Baby boomers are aging to the point where they feel a lot better about themselves if they can access these kinds of procedures,” Simon says. “Plus there is a big movement among 20- and 30-somethings to pursue these cosmetic options. We’ve had a very robust economy, so people can afford to pay for these procedures out of pocket.”

And then there are those companies that cover two bases: the medically necessary and the cosmetically attractive. There is, understandably, some buzz among mostly male, middle-aged VCs about one such startup, called AirXpanders, which makes a tissue-expansion product used to treat patients with burns, amputation or other trauma.

“The market for that is relatively small—about $250 million,” says Driscoll of Claremont Creek Ventures, which has not invested in the company. “But the home run that they’re thinking of would be using their product for expanding the scalps of hair-challenged men for full hair restoration. That would be a big deal if they could achieve that.”

Swinging for the fences

Recently we’ve seen the emergence of true blockbuster opportunities that have the potential to become fully integrated companies built around half-billion or billion-dollar products.”

Ashley Dombkowski, General Partner, MPM Capital

Many medical device investors are now adopting a “go big or go home” attitude. Ashley Dombkowski, a general partner at MPM Capital, says she’s not interested in me-too devices. “Recently we’ve seen the emergence of true blockbuster opportunities that have the potential to become fully integrated companies built around half-billion or billion-dollar products,” she says.

Dombkowski points to areas such as macular degeneration, obesity, gastro esophageal reflux and neural modulation as holding out the brightest hope. MPM participated in a $41 million series C round last year for NeoVista, which offers unique treatments for age-related macular degeneration, which causes failing eyesight.

Today elderly patients with macular degeneration have to visit their physicians on a monthly basis to receive a series of painful and expensive injections. NeoVista is pioneering a device that delivers radiation to the back of the eye, substantially reducing the number of injections needed to treat the ailment.

Another promising startup in MPM’s portfolio is year-old Nevro, which treats chronic pain through neural stimulation. “Today there are billions of people who have need of chronic-pain alleviation and yet the market is only about 5% penetrated,” Dombkowski says. MPM and the Mayo Clinic seeded the company to the tune of $5 million. Nevro is developing an energy-delivery system that promises a greater degree of effectiveness than any other neural stimulation device.

Some health care VCs are also tapping opportunities around the convergence of drug therapy and diagnostic devices. These are medical devices that either help deliver a particular drug or allow patients and physicians to gain a better understanding of their therapy needs.

A leading company in this field is Apieron, which just raised a Series E round of $17 million in June from Alliance Technology Ventures, Canaan Partners, Draper Fisher Jurvetson and Onset Ventures. The company is developing a device the will let serious asthma sufferers monitor lung inflammation and use that information to administer appropriate drug therapy.

“Treatments will be transferred from office delivery to home delivery and patients will be better able to tune their drug delivery,” says Hutton of Canaan.

Booming market

The big-picture incentive for medical device investment is the aging population of America and, a critical corollary, that population’s refusal to relent to old age. Simply put, people want to feel as young as they can for as long as they can and they will buy what it takes to do so. If they can’t buy it, they’ll advocate for reimbursement.

“Demographics drive our business,” says Delphi’s Maroney. “Baby boomers like me tend to be active and we don’t want to suffer in silence. We’re going to get stuff fixed.”

Having invested in medical devices since 1985, Morgenthaler has discovered that there are three areas that consistently pay off: devices that improve vision, are less invasive or help people to age gracefully. “We are all aging and certainly we’d like to age gracefully and that means we invest in devices and drugs that allow us to look good and feel better as we age,” Bellas says. “The theory here is that if you sustain a high level of activity until you drop dead, you’ve had a great life.”

A worthy goal for any investor.