Med tech has been the single hardest place to invest in the entire universe of venture capital-backed industries, said New Enterprises Associates partner Justin Klein during an insightful speech delivered last year at the Maryland Entrepreneurship expo in Baltimore.
In spite of the tumult, NEA remains a pillar of med tech venture capital. The sector accounts for about $1.2 billion of the firm's $4 billion healthcare portfolio, a high percentage considering the surge of biopharma and digital health financings in recent quarters, which constitute the rest of the portfolio, along with care providers.
According to the MoneyTree report, biotech companies raised $2 billion Q3 2015, double the level in 2014. But first sequence (seed or Series A) med tech financings are at levels last seen in 1995, and overall deal values are around 75% of their pre-financial crisis peak of $3.6 billion.
Klein blamed the sad state of affairs on risk-averse FDA policies enacted around 2008.
Prior to that, "a company could initiate clinical studies in the U.S. with a certain amount of evidence of safety and how the product would be used including animal studies, benchtop data and international clinical trial data," he said.
But around the time of the administration change "the bar shifted, and you basically had to complete all preclinical bench and animal testing before ever touching a patient in the U.S., even if you had randomized controlled trial data from hundreds of patients abroad."
Many VC firms exited the industry or only funded FDA approved products. "A lot of our peers, and certainly NEA included, had to fund our companies through this 2008 to 2012 period, where there wasn't a lot of fundamental value creation or advancement of these programs. In many ways that decimated the sector," he said.
Dr. Jeffrey Shuren, the head of the FDA's device arm (CDRH), has made revitalizing the environment for U.S. clinical trials a priority, along with reforms aimed at improving the speed of approval such as the Expedited Access Pathway for breakthrough devices.
Klein acknowledged recent improvement at the agency, saying, "I think it took a lot of work with FDA and Congress to kind of shift that conservative stance to something a little bit more reasonable, but over the last 18 months, I've seen a big improvement in the dialogue with FDA." But he added, "I'm still reticent to undertake some really novel Series A investments in PMA companies, particularly if there's reimbursement risk on the back end."
In fact, reimbursement risk is beginning to rear its ugly head just as the regulatory situation at the FDA's device arm improves. It's increasingly common to hear at conferences that getting paid for innovation by public and private payers (and not FDA regulations) is now the biggest impediment to more med tech VC deals, and Klein concurred, saying, "I think reimbursement has sort of reasserted itself as the scariest part of investing in med tech."
Klein is worried about the possibility of governments and federal agencies erring "in the analysis around innovation and evidence in determining cost effectiveness."
"Innovative products have a longer learning curve to get up, and yet over the long term, they can and should overcome established products in terms of cost, effectiveness and value to the marketplace, but if they don't get the opportunity at the front-end, it's going to stifle a lot of that opportunity," he said.
Besides regulatory and reimbursement risk, there are other constraints on med tech venture capital. Klein said he can only join 10-12 boards and be effective. He also devotes a lot of his time to helping portfolio companies find additional financing or, even better, "exits" in the form of a sale or IPO. This logistical constraint makes the departure of several VC firms from med tech investing all the more worrisome.
In addition, med tech startups don't generate the gargantuan financial returns of their cousins in the IT and software industry, so venture capitalists have to be more cautious at the outset. Unlike in tech, one home run won't make up for a series of strikeouts.
Outside investors like France's Sofinnova Partners (a lead investor in Fierce 15 company Shockwave Medical) are helping to fill the financing void. And Chinese investors HOPU Investments and YuanMing Capital led med tech's largest deal of 2015, a $200 million financing of U.S.-based proton therapy system maker Mevion Medical Systems.
Klein wants NEA portfolio companies to benefit from the trend as well.
"We are seeing companies get good financings done with partners from overseas. We'd of course like to build those relationships because NEA may have 30 portfolio medical device and healthcare tech companies and 5 or 6 of them are raising capital at any given time. It's fair to say it's hard to raise rounds of capital in med tech at any stage. The more we can do to find these sources of capital looking for partners that we think are aligned with us, it's great," he said.
Recent NEA-led financings include a $25 million Series B round for hearing aid company Eargo, a $21 million Series A round in support of Personal Genome Diagnostics and a $20 million round to finance Cardionomic, developer of a neuromodulator to treat heart failure.
Since 2013, big exits from NEA's med tech portfolio include drug-coated balloon maker CV Ingenuity, skin-tightening specialist Ulthera, electrophysiology player Topera, spinal cord stimulation company Nevro ($NVRO) and dry eye device start-up Oculeve, suggesting the VC environment is improving.
To determine what NEA (or other VCs) might be interested in next, look for large unmet needs, such as treatments for early-stage renal disease. "Are there medical device opportunities that could improve the dialysis experience, or in my view, ideally, therapies that extend somebody's renal sufficiency before they reach the need for dialysis?" Klein asked. "That alone would save costs and morbidity."
So far, "drugs and devices haven't really made a dent in affecting early-stage renal disease," according to Klein. While NEA waits for the technology to develop, it is investing in dialysis service companies (namely DSI Renal and Indian provider DaVita Nephrolife), "because that's where the market opportunity is today."
Klein was less bullish about digital health companies, saying the firm has been very selective about the commitments it's made due to high valuations.
"Building a business in healthcare IT business, broadly, is very challenging. Digital health often incorporates either a consumer as a customer, which can be a challenging avenue to drive revenue, or selling to a hospital, which is a very complex environment in which to sell products," he said.
Still, investing in the field can be lucrative. Klein noted the phenomenal returns life science cloud computing company Veeva Systems ($VEEV) generated for Emergence Capital, which turned a $4 million investment into a $1.2 billion stake in the now-public company.
In addition to discussing the broader VC environment, Klein devoted a large portion of his remarks to discussing NEA's approach to investment and portfolio management.
NEA aims to invest $5 million to $15 million during Series A rounds, and $30 million over the lifespan of a portfolio company. The goal is to cover a third to half of a company's capital needs prior to commercialization, Klein said.
A firm potentially worth $150 million upon its exit from the portfolio is at the "lower end," but could be funded if NEA is one of the only investors, Klein said. The firm prefers to work with other investors when funding large companies.
He said that the company is comfortable doing deals in conjunction with large strategic investors (industry players like Medtronic), but is put off by exclusive options to acquire and other similar tactics that limit the upside of financial returns to be achieved upon exit.
One of the challenges of med tech venture capital, as opposed to investments in software and other tech companies, is the lack of "step-ups," meaning the price per share doesn't always rise during later stage rounds, to the detriment of early-stage investors like NEA, who would otherwise benefit from less dilutive funding from subsequent investors.
"In venture there's always this thought that I want to raise just enough money in the Series A because then I'm going to get a step-up in the Series B and I'll get less dilution. So if I need $10 million, I'll raise $3 million now, and I'll raise the next $7 million at a less dilutive price, and I'll own more own of the company at the end. Totally rational, right? Except in medical devices there aren't necessarily step-ups from the Series A to the Series C, even with great progress," Klein said.
Instead, the financial returns are concentrated at the end of the investment. It's not uncommon for a company with a valuation of $65 million prior to commercialization to find a suitor willing to pay $400 million. "That's typical in med tech where acquisitions frequently happen after seminal events like FDA approval," Klein said during his speech.
One consequence of the lack of step-ups is valuation compression, according to Klein: "On the one hand, we have found opportunities to invest in mid to later-stage companies ready for pivotal trials at what were more like early-stage valuations. At the same time, that's not been healthy for the ecosystem. It's been really hard to get a Series A company funded, but the companies that are getting funded are very high quality. And what we're seeing today is that there are fewer companies eligible for Series B and C investments."
Klein also explained NEA's approach to valuation, saying, "Fundamentally, it comes down to the capital required. Not only for this round, but what is required over the course of the company's path to market. We try to triangulate our way to a valuation that certainly gives the founders and the management team a lot of equity ownership so they're incentivized to build for the long-term, but also enables the company to raise money as it needs it going forward," adding that assigning an overly high valuation to a start-up leads to undesirable "down rounds" (the opposite of step-ups).
The entrepreneurship expo was sponsored by the nonprofit Maryland Technology Development Corporation. TEDCO is partially financed by the state, and invests in Maryland companies to promote economic development and make a financial return for investors. The corporation recently became the manager of a $100 million early-stage venture fund that was previously run by the state government. -- Varun Saxena (email | Twitter)
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