Outlook ’04: MED TECH –

With little headway being made with drugs designed to treat Alzheimer’s and Parkinson’s, medical device makers have stepped up with gadgets that physically stimulate the brain. That’s just one example of an emerging area in medical devices: creating technology to try to solve medical problems that doctors have had little success treating with drugs. It has made the boring sector suddenly hip and has attracted lots of attention from venture capitalists.

With major advances in technology, medical device companies are finding many more opportunities than they had a few years ago, particularly in the market that intersects with pharmaceuticals. “We are thinking a lot about solving medical problems that have been thought of as drug problems with devices,” says Trevor Moody, a partner with Frazier Health Care Ventures. “We’ve made some investments related to that. The theme has been to look at the areas that drugs go after and look at the areas that haven’t been served by drugs and solve those problems with devices.”

There has been “quite an entree of devices coming into the pharmaceutical world,” agrees Daniel Cole, a general partner with Spray Venture Partners. The intersection of pharmaceuticals and devices is creating significant opportunities for companies working on the cutting edge – venture-backed startups. And that is driving more interest by VCs, who see demand from large companies that increasingly rely on VC-backed companies to do their R&D. Those large companies “are going to have to turn to the VC-backed guys,” says Barr Dolan, a general partner with Charter Venture Partners.

The reason for this is a matter of scale. “The importance of intermediate-sized companies is going to skyrocket,” says Steve Bent, a partner and leader of the life sciences industry team of law firm Foley & Lardner. “The blockbuster mentality has made it impossible for the Big Five to develop anything with less than a $300 million market. What Big Pharma can’t or won’t do the VC-backed companies are going to do.”

Where the Money Is

Venture investors are also attracted to medical device makers because they often target established areas – that is, areas where lots of money is already being spent. If device makers can build a better mousetrap, it’s just a matter of shifting the dollars to their solutions. Many of the most popular investment areas in 2004 will be familiar, not segments no one has heard of, says Corey Mulloy, a principal with Highland Capital Partners. “These aren’t going to be areas that others have not thought about yet, but areas that billions have already been spent on,” he says.

VCs say they expect emerging medical technologies to drive more investment in the overall medical device market this year. “There’s been a lot of money that’s been held back and there’s a lot of pent-up demand,” Bent says. “There are a lot of opportunities that have gone wanting. We’re hopefully going to see a storm that will bring out a lot of flowers that have been lost in the past drought.” Investments in device companies were flat last year, with VCs investing just over $1 billion in medical device companies in the first three quarters of 2003, compared to $1.4 billion in all of 2002.

Chief among the hot sectors that medical device investors are exploring are drug-coated (or “drug-eluting”) stents. A stent is a tube-shaped device made of metal or plastic that is inserted into part of the body, like a blood vessel, to support it and keep it open.

“The drug-eluting stents are going to be big sellers,” Dolan says. “There’s a lot of interest in the short term with the venture capital guys and in the long run with the device companies. Down the road you’re going to see people combining drugs and devices for all kinds of diseases. Right now the interest is more in the direction of heart disease.”

Psyched for Stents

Last year venture capitalists put their money where their mouth was, funding stent companies with the idea that the market will develop this year and beyond. Early in December, heart stent developer Percardia of Merrimack, N.H., received $23.5 million in a Series D round, bringing its total capital raised to $55 million. Investors in the startup include Advanced Technology Ventures, Atlas Venture, Crescendo Ventures, Medtronic and Vanguard Ventures.

Similarly, Conor Medsystems, which makes drug-coated stents for heart patients, took in $28 million in a second institutional round of funding in October. Easton Hunt Capital Partners led the round in the Menlo Park, Calif.-based company. Other investors included Highland Capital Partners, Brookside Capital, Hambrecht & Quist Capital Management, Maverick Capital and Radius Ventures.

Both of the companies are serving a potentially enormous market. Percardia estimates that 300,000 heart patients in the United States will undergo coronary bypass surgery this year and that 1.08 million patients worldwide will undergo angioplasty.

Enthusiasm is high for drug-coated stents despite some setbacks for the technology. Last April, the FDA approved the Cypher heart stent, which is manufactured by Johnson & Johnson subsidiary Cordis. Later last year the FDA issued two safety warnings about the stent, citing the development of blood clots in patients who were fitted with the device. J&J rival Boston Scientific has partnered with Angiotech Pharmaceuticals, formerly a venture-backed company, to develop the next marketable drug-coated stent. Guidant, another publicly traded company, is developing a stent on its own.

Other devices besides stents that are attracting venture capital include implantable devices that act as sensors, release drugs or perform some kind of therapy where drugs have failed to produce sufficient results. For example, you could theoretically create an insulin sensor that would be inserted into a diabetic person’s body and release insulin at a prescribed rate, eliminating the need for the person to receive multiple injections daily.

“We’re going to see more real-time feedback loop activity,” says Harry Rein, a former managing partner with Canaan Partners and a general partner with Foundation Medical Partners. “There is probably some likelihood of more implantable sensor devices. There is now greater ability to collect and capture data, which means for the physician a better likelihood of a better outcome for the patient.” Publicly traded company SpectRx, while looking to venture capitalists for PIPE funding, is focusing on development of insulin delivery products and glucose monitoring systems. The company says that the insulin pump market is currently $270 million a year.

In the area of heart disease, at least one startup is working on an implantable device to unblock clogged arteries, something that drugs so far haven’t been able to do. OmniSonics Medical Technologies makes an implantable wire to deliver sound waves to unblock clogged arteries. The company’s product was approved for use in Europe and Australia and is currently being tested in the United States. OmniSonics, based in Wilmington, Mass., is backed by such firms as Canaan Partners, Domain Associates, New England Associates and Prism Venture Partners.

Good Vibrations

Implantable devices that help patients with brain disorders have also garnered enthusiasm from some venture capitalists. “I think you’re going to see more and more activity there,” says Frazier’s Moody. “Big diseases that affect the brain, pretty much all of them are receiving attention in the device community.” Areas of investment include deep brain stimulators that provide therapeutic benefit for Alzheimer’s and Parkinson’s patients as well as other maladies that affect the brain, such as depression or stroke. While the development of advanced devices for nerve treatments is in its earliest stages, funding for companies that focus on neurological disorders remains strong. Late last year, companies that continued to bring in venture funding included Asterand, a Detroit-based tissue bank that specializes in researching cardiovascular and neurological diseases.

Some of the device areas VCs are looking at are invisible to the naked eye. Steve Bent sees upcoming opportunities in what are called quantum dots, nano-scale devices not unlike light bulbs. Researchers can attach these dots to molecules to be used for medical diagnostics. “It will initially be big in the research area, but it has such clear opportunities elsewhere,” Bent says. “That may not happen this year, but it will in the next decade.”

VCs are betting big on this area of nano-devices. Nanosys, which is helping to produce biosensors, is backed by a long list of investors, including Abingworth Capital Management, CMEA Ventures, Frazier & Co., Institutional Venture Partners, MPM Capital and Schroder Ventures Life Sciences. Among those participating in the Hayward, Calif.-based company’s $38 million Series C round last year was SAIC Venture Capital, whose parent company SAIC also announced a development agreement with Nanosys.

While medical diagnostic investments haven’t brought great returns so far, investors show cautious appreciation for the space and hope that this may be the year that technological advances and business viability meet. “Medical diagnostics has been viewed as a pretty tough space to make money in,” says Bob Zieserl, managing director with KB Partners. “We’re aware of that, but we will cautiously evaluate deals in the space.” He notes that KB Partners is currently looking at investing in a molecular diagnostic company. “This is a whole new class of products using nanotechnology,” he says. “That meets a profile for us in the diagnostic space and it really is breakthrough technology.”

Weighty Matters

In addition to replacing drugs, medical device makers continue to make headway in creating technology to treat medical problems that typically require surgery. Take gastric bypass surgery, for example. It has become increasingly popular with its celebrity exposure, but the surgery is highly invasive and risky. Death resulting from gastric bypass surgery is a distinct possibility. “When you have that kind of unmet need and opportunity – a highly invasive and not efficient procedure – startup companies see opportunity,” says Michael Carusi, a general partner with Advanced Technology Ventures.

Highland Capital Partners is one of the venture firms eyeing alternatives to gastric bypass surgery. “We are thinking about the general area across different types of solutions,” says Mulloy of Highland. “Our view is that there are going to be a lot of treatments and therapies. We’re absolutely looking at areas that might be less invasive and less risky to compete with the gastric bypass.”

And while obese Americans are trying everything in their power to shed pounds, the publicly traded medical device companies will be the ones doling out generous helpings of liquidity dollars to venture-backed startups. VCs are setting the biggest place at the table for the established device companies with big appetites and money in the bank.

In general, device investors say, these large established medical device companies are doing quite well, but they are feeling pressure to maintain significant growth. They also have the culture and mentality to look at new venture-backed companies as a source to drive that growth. VCs always take this into consideration when looking at deals and treat the device giants like customers. “Historically in the device world the IPO route has not turned out to be a historic success,” Rein says. “It’s not to say that there haven’t been some good device companies that have gone public, but more tend to get bought than go public.”

Moody expects to see some medical device companies launch IPOs this year, so long as the economic recovery is not derailed, but he cautions that the IPO door is not a reliable exit. “We don’t bank on IPOs,” he says. “We expect that liquidity of many of our companies will be in a sale to one of the established medical device companies. That they’re ready to do deals is driving interest in the sector.”

“My sense right now is that there’s renewed interest in [device startups],” says Carusi. “I don’t want to say that the sector is heating up, but there certainly seems to be more interest than there has been in the past.” He stresses that the sector’s major attraction to VCs is its stability. People certainly aren’t going to always want to buy 50 pounds of pet food over the Internet, but people will always be in need of medical care. Thus, while returns were never enormous, the returns were there when IT wasn’t. He cautions potential investors not to expect 100-to-one returns. “Today, a 3x or 5x return is pretty good,” Carusi notes. “People see it as a relatively efficient market where you can find your way to liquidity through acquisition in four to six years.”