It’s a hard world out there for those looking to turn their cutting edge medical device ideas into commercial products, with investors shying away from early-stage companies in favor of more established medtech enterprises.
In fact, less capital went into medical device companies last year than in any year since 2001, according to a report from Silicon Valley Bank, accounting for only 7% of overall venture capital investment in 2013.
"It is difficult to attract capital to early-stage device opportunities when the exit is likely further away and development and regulatory risks are typically greater than in FDA-approved, later-stage companies," according to the SVB report, Healthcare: Trends in healthcare investments and exits. "We believe this reluctance of venture and corporate venture to support early- stage device investment is shortsighted and will impede innovation."
MassDevice.com asked SVB managing director Ben Johnson, whose purview covers a swath of the Midwest from Minnesota to Texas, what’s behind investors’ reluctance to back new medtech ideas. Following is a transcript of our chat, edited for clarity:
MassDevice.com: What’s your take on the climate out there for medical device investment, especially for earlier-stage companies?
Ben Johnson: The funnel for early-stage life science investment has not only gotten smaller, but it is arguably minuscule. It is very difficult right now for the average life science entrepreneur to obtain equity investment capital, seed capital, from the traditional sources, venture capital (that being institutional venture capital).
While some companies are getting funding from angel groups and from a larger amount of [National Institutes of Health] grants and so forth, and while strategics are playing a more important role today in the deployment of life science, seed-stage equity, and early-stage equity, it’s really the institutional venture capitalist who until 3 or 4 years ago were the predominate vehicle at least in our minds of supporting interesting new technologies.
The reason that venture capital sort of backed away from that space in the early stage is because, in my opinion, of the idea that you’re going with the [Affordable Care Act] from a fee-for-service model to an outcomes-based model. That makes it very difficult for any company that has any promising technology to be able to figure out how they can price their products to make a reasonable return for their investors. That level of uncertainty has just caused limited partners, who ordinarily would invest in venture funds, to take their capital and redeploy it elsewhere – to social media or wherever else they choose to invest.
So it’s just created this sort of void in early-stage equity capital in the markets. Silicon Valley Bank works with both early- and later-stage companies; my group in Minneapolis covers life science companies for the central United States. We are going to deploy our capital as best we can, wherever we can, and right now because there’s an absence of activity in the early stage, the preponderance of activity that we’ve been lending into has been in later-stage companies – companies that have a commercial product, that have reimbursement, and so forth.
When you massively overhaul a healthcare system by migrating from a fee-for-service mentality to an outcomes-based mentality, that obviously will do a lot to push down on costs, because doctors won’t have this incentive to use the product that puts the most money in their pockets with the same level of efficacy. The have to actually think about, "Well, for the same level efficacy, what’s the best with the least burdensome dollar amount that’s placed upon the system?"
But at the same time, if you think about how innovation happens in medtech, it’s very much like the electronics industry, where a lot of the innovation is actually incremental – you’re trying to make the product better. If you think about any type of electronics product, any time you come out with a better product it enters into the market at a premium price relative to the existing products on the market. Think about the VCR, for example. Over time that price comes down and then eventually the product goes away as it’s outmoded by technology that’s revolutionary, in this case like the DVD player.
Most of what I’ve seen in medtech is not dissimilar to that, in terms of how innovation happens. If you can take the ACA principle and apply it to the electronics industry, someone else or some other governing body will impose what price you can charge for your VCR or DVD player. That would cause people to think really hard about how much money they will want to invest in that technology, because in medtech not only do you have to come up with the technology and make sure it works, but you’re subject to the FDA also.
When you start adding these things up, it dissuades investment in the sector. In terms of innovation in medtech, I think a lot of companies and investors are pausing and saying, "OK, how are we going to be able to figure this out? Let’s take a step back and not put a lot of money in the early stage of innovation."
MassDevice.com: Is FDA approval or CE Mark approval a prerequisite for funding these days? Does the regulatory bar impede medtech investment?
Ben Johnson: Generally speaking, yes! Absolute exclamation point! The bar has been increasingly raised and it seems like it keeps getting harder for companies to get approval, whether it’s through 510(k) or PMA. I can think of companies that I have lent money to over the past few years that are pre-revenue, and those tend to be situations where the company is a pre-revolutionary technology that in all likelihood will take a lot of cost out of the healthcare system.
Where you’re seeing investment in companies these days that are early-stage in medtech, a lot of these technologies are solving a cost problem. Whereas 5 years ago the conversation was about how disruptive your technology was from the point of efficacy. There’s been a shift in terms of investor sentiment toward this idea that if this product does a good job and takes cost out of the system, chances are whatever we get paid for it, it will be an economic benefit to our company and therefore our investors.
But it’s not the FDA that is the Number 1 thing on the mind of CEOs these days. It’s reimbursement, the idea that even if we get our FDA approval it doesn’t mean that we have a business that has enterprise value, because we don’t know if we are going to get paid for our product.
MassDevice.com: What are your takeaways from the Medtronic-Covidien merger?
Ben Johnson: It’s hard to ignore the Medtronic-Covidien deal, that a company like Medtronic, with more than 50% of revenues from overseas, is looking into investing in this country and seeing that deploying dollars or putting products into this market comes with a very heavy tax price. They’re going to have to look at that and say, "Well, if we put that same product in another country with a lower tax environment, are we going to be better off?"
They’re voting with their feet now, by saying we may be better off if we actually reincorporate somewhere else. For medtech I think it’s exacerbated relative to other industries, because now you have in general a high business tax environment in the United States but you also have a medtech tax that’s a tax on sales, not on profit.
Medtronic is saying that they’re going to be taking most of the money that’s sitting offshore and actually investing it in the United States to support innovation. But are they talking about early-stage clinical development innovation, or are they talking about commercialization? Because while there might be an absence of early-stage investment funding, I could easily see a situation in which strategics take advantage of that lack of capital by investing more in early-stage company in the United States and then offshoring their commercial development.
One of the realities of the situation we’re in right now is that, while it might be easy for a company to move its tax domicile from 1 country to the next, it’s very difficult to disrupt very long-term supply chains or value chains. So, for example, think about Harvard, Stanford, MIT and all the research that happens at just those institutions, not to mention the other areas of either clinical or academic research. Those value chains have been built over arguably centuries, right? So it will take arguably decades for those value chains to migrate to China, as an example.
The same holds true for companies that commercialize. If you’re going to be setting up a factory in Ireland and you’re going to be selling to Europe, it takes a lot of effort to try and dismantle that value chain. When I put myself in the shoes of a company like Medtronic, do they try to continue to invest in what is arguably the best early-stage innovation climate or in the invention climate?
The distinction between innovation and invention is that with invention, you come up with this great new idea; innovation is, can you make a business out of it? A good way to summarize my point is that invention is going to be happening for a long time in the United States, but innovation might be a little bit rocky here for a while as we see through the changes to how healthcare is deployed in this country. For a company like Medtronic to continue to invest in the United States, I think that’s great, but I wonder if the fruits of those labors will still move offshore based on the function of our tax code.