How investors make money in MedTech

If you’re interested in investing in exciting medical technology (MedTech) companies and you’re wondering “so how do I make money in these deals?”...

In this article, we’re going to take a deeper look at one of the most misunderstood aspects of investing in MedTech: Exits.

But before we jump into M&A and IPO strategies, the first thing you must understand is how funding in MedTech is different than other technology companies.

The Fundraising Ecosystem in MedTech

When most investors think of early-stage investing, they usually think of the high-flying software companies that have defined Silicon Valley for the past 20-odd years.

After all, several of the most valuable stocks in the world – like Apple, Google, and Microsoft – all got early funding from venture capital firms.

But back when many of those companies were just starting, tech investing was still a very new idea… and venture capital was the only place crazy enough to fund these ideas.

However, the playbook for tech investing is pretty well known at this point. The software industry has greatly matured since the dot-com bust and it’s not nearly as “risky” as it once was.

This is due in part to the entire tech ecosystem evolving and becoming more decentralized. This, in turn, has significantly brought down costs to start new tech companies.

In fact, In 2008, Y-combinator founder Paul Graham made a rather shocking statement...

There’s a lot to unpack in this statement, but perhaps the most interesting one is this...

Most professional investors who allegedly specialize in high-risk ventures aren’t good at taking risks.

Even worse, they’re investment models are based on old paradigms that aren’t necessarily useful in today’s investment landscape.

For tech companies, it’s pretty easy to see how radically early-stage funding has changed over the past 20 years.

In the early 2000’s, there was already a well developed ecosystem of VCs in Silicon Valley…

But they tended to prefer to fund companies that seemed like a “sure thing” instead of taking a chance on risky startups with unproven technical founders.

And because these VC’s were pretty much the only game in town funding deals, they got to dictate terms.

For the founders, this meant they usually had to agree to non-founder-friendly terms from the VCs in order to get funding…

And had the very real risk of being ousted from their company and being replaced by the VC’s favorite band of suits.

But then, the modern tech infrastructure started to develop…

A combination of open-source software, modern web frameworks, SaaS developer tools, cloud hosting, and better distribution channels made it easier for Founders to start developing their products.

This meant technical founders who couldn’t raise money from VCs from the power of an idea could instead bootstrap their way to a “minimum viable product” to get early traction (and then funding).

This in turn shifted the balance of power into the founders favor…

And in turn, began to change the entire fundraising landscape for tech companies (and the types of deals founders could negotiate).

Easy access to flexible, institutional seed funding led to an explosion of tech startups, and today this is the default path for tech startups to get started.

However, in MedTech, it’s not like you can max out your credit cards, quickly build a new drug or device, test it on a bunch of people, and hope for the best.

In many cases, it requires millions of dollars and years of work before a product can be taken to market and commercialized.

Not to mention, those multi-million dollar check sizes often mean non-founder-friendly deal terms.

But the same way the tech scene brought down costs by creating new infrastructure…

We’re starting to see the same thing happen in the world of medicine.

According to Jared Friedman, Managing Director at Y Combinator…

So what does any of this have to do with MedTech IPOs?

Before the 2000 dot-com bust, it was normal for smaller startups to IPO “early.”

Why? Because going public meant potentially getting access to large quantities of capital required to fund research and development (R&D) and scaling.

But because there’s so much money floating around in private markets, companies are staying private for far longer than they used to.

Now, we see tech companies raising billions of dollars in private money – and have large and growing revenue – before even thinking about an IPO.

MedTech companies, by contrast, tend to have no revenue and burn tons of cash each year (at least until a product is ready to market).

As a result, there’s often a lack of available private markets funding (or at least at deal terms the early investors and Founders were willing to accept).

Thus, the decision to go public is more centered around generating public market enthusiasm and raising money to continue funding research and development.

But thanks to the JOBS Act, everything changed for how BioTech and MedTech companies can get funding.

According to a Sept, 2020 article written by Bruce Booth, partner at Atlas Ventures...

But the so-called “crowdfunding” exemptions aren’t just for direct-to-consumer brands that can quickly iterate and launch new products.

In the MedTech sector – which involves a rather convoluted product development process – it creates an opportunity to not only raise founder-friendly capital…

But build brand awareness with potential patients (or people who care for them) who can then ask their doctor for the solution...

AND build awareness among the healthcare providers who might want to use the technology with their patients.

Hopefully, this means the opportunity to develop novel and breakthrough medical technologies that can save lives.

And for investors, if the company is successful at its mission while private, it could translate into an opportunity to go public at potentially a much higher valuation than if they tried to exit as soon as possible by M&A.

While we almost always prefer liquidity via IPO than we do from M&A, statistically speaking, medical devices are more likely to exit via M&A.

But what does an acquirer look for in a deal?

To answer this question, we turn to one of our favorite market models…

The Consolidation-Endgame Curve

The Consolidation-Endgame Curve framework (also known as Consolidation Curve or Endgame Curve) is not a well known framework, but is one that offers potential insights into market dynamics and competitive strategies.

This framework was developed by the management consulting firm AT Kearney, and then published in the 2002 book “Winning the Merger Endgame: A Playbook for Profiting From Industry Consolidation”

The authors research – based on an in depth analysis of 1,345 large mergers by 945 acquiring companies – revealed some rather shocking conclusions known as “The Five Maxims of the Endgames Curve”…

1. Industries tend consolidate and follow a similar course

2. Merger actions and consolidation trends may be predictable

3. The Endgames curve can be used as a tool to strengthen consolidation strategies and facilitate merger integration

4. Every major strategic and operational move should be evaluated with regard to its Endgames impact

5. Endgames positioning offers a potential guide for portfolio optimization

Here’s how their model works in practice...

Once an industry forms – or is deregulated – it will likely move through four stages of consolidation: Opening, Scale, Focus, and Balance & Alliance

By appropriately identifying the stage, understanding the defining traits and behavior of our stage, we can better understand – and potentially predict – market behavior and trends.

• Stage 1: Opening – There is little or no market concentration and the first consolidators may appear. Newly deregulated, start-up, and spin-off sub industries occupy this space
  

• Stage 2: Scale – Size begins to matter. Major players begin to emerge and tend to take the lead in consolidation. Concentration rates can be as high as 45%.
  

• Stage 3: Focus – Successful players extend their core businesses, exchange or eliminate secondary units, and continue to aggressively outgrow the competition
  

• Stage 4: Balance & Alliance – a few players tend to dominate industries with consolidation rates as high as 90% among the top three companies. Large companies may form alliances with other giants because growth at this stage is more challenging.

According to the authors, “an industry will take on average 25 years to progress through all four stages; in the past it took somewhat longer, and in the future we expect it to be even quicker.”

Furthermore, they provide an interesting analysis of the Global Healthcare industry at the time.

The authors concluded the industry as a whole was transitioning from Stage 2 to Stage 3.

In doing so, each company was experiencing the challenges of this transition, namely “slow growth, difficulty with patent expirations, plummeting share prices, margin pressures from large competitors, and the constant threat of being an acquisition target.”

As an interesting example, they suggest Johnson & Johnson – despite challenges in its core pharmaceutical business – diversified its portfolio by acquiring and growing businesses in the medical equipment industry (Stage 2 at the time) and biotechnology (Stage 1 at the time).

With this in mind, let’s fill in the timeline from 2002 until today (and how it’s changed the M&A landscape for MedTech).

During the late 2000’s and early 2010’s, the medical device industry experienced increased acquisitions of undeveloped technology patents & IP.

Why? Because as noted earlier, when an industry is transitioning from Stage 2 to Stage 3, one of the challenges is dealing with patent expirations.

While we don’t have the time to dive deep into patent strategies – and the creative ways they can be extended and defended – generally speaking, a patent lasts for 20 years.

But once the patent expires, the company's government protected products are now exposed to greater competition.

Acquiring promising new IP enables the development of next-generation products while also bolstering freedom to operate (FTO), and protection against frivolous infringement lawsuits "Patent Trolls".

However, after acquiring a patent outright, an acquiring company still has the task of actually developing the device, clearing it with regulators, collecting clinical data on its efficacy, and then fully commercializing the patented technology.

For this reason, the MedTech industry has moved away from buying unfinished products and undeveloped patents in exchange for finished products with patent defense.

Then, according to a 2013 article published by the Medical Device + Diagnostic Industry (MD+DI)

This – on top of fears that the FDA 510(k) process may change – encourage companies to seek growth through acquisition vs innovation.

Instead of buying patents, they wanted to acquire fully developed products that have already cleared regulatory hurdles, have clinical data, and ideally partial commercialization.

This, in turn, began to drive up valuations and deal size; the more risk-reducing milestones a device has cleared, the higher valuation it can command.

And for our Equifund members who have invested – or are considering an investment – in Kleiner Device Labs, it may provide context for where we are in the Endgame curve (as well as potential exit strategies).

This year, we’ve seen some rather interesting spin-offs in the medical device category…

On Feb 5th, 2021, Zimmer Biomet announced they are spinning out their dental and spine business into a new publicly traded company called ZimVie.

On March 4th, Colfax (NYSE: CFX) announced its intention to separate its fabrication technology and specialty medical technology businesses into two differentiated, independent, and publicly-traded companies.

On November 9th, General Electric (NYSE: GE) announced plans to divide the conglomerate into three companies; aviation, health care and energy.

On Nov 12th, Johnson & Johnson (NYSE: JNJ) announced plans to spin off its consumer health division (which sells products like Listerine) to focus on its pharmaceutical and medical device business (including orthopedics) – which is on track ​​to generate nearly $80bn in sales this year.

By definition, these spin-offs seem to indicate we may be in Stage 3: Focus…

And perhaps more relevant for investors interested in early-stage medical device companies, the recent restructuring and spin-offs of larger corporations may signal a new era of M&A activity in MedTech.

How strategic investors turn into buyout offers

If you’re considering an investment into any early-stage MedTech company, patience is key.

Unlike tech companies that can seemingly bootstrap their way to an MVP and quickly scale…

Developing new medical devices takes substantially more time and money to bring to market and successfully commercialize.

Whenever we’re working with companies raising money (called “Issuers”), one of our main objectives is to help them put together a multi-year plan for raising capital.

We call this the Map to Money: an iterative approach to fundraising that minimizes dilution for early shareholders and maximizes potential gains.

The goal of this capital-raising strategy is simple: Don’t raise capital when you need it. Do it when you can get the best price!

To do this properly, it means having a holistic understanding of what assets the business needs to grow... if it makes more sense to buy, rent, or build those assets... and how to finance them at the right time for the right price.

To some degree, this will be decided by the type of business model being built.

A traditional, linear business takes in raw materials/components, creates products or services and sells them to its customers.

For this reason, a linear business owns its own inventory and is often considered “asset heavy.”

In contrast, a platform business facilitates value exchanges between two or more interdependent groups, usually consumers and providers.

This usually means the company does not create or own inventory and is considered “asset light.”

For example, Hertz Rent-A-Car owns a fleet of vehicles (asset heavy) whereas Uber does not.

Neither model is necessarily “better” than the other. Each has its own advantages and disadvantages.

However, the most obvious disadvantage of an “asset heavy” business is the up front capital requirements.

This is especially true if the company is developing new pharmaceuticals or medical devices!

There’s already enough risk in successfully bringing a new drug or device to market…

And raising early stage capital to finance a massive supply chain build out could be highly dilutive (i.e. expensive) for early shareholders.

However, the company still needs to raise capital to fund research and development… and to do that, they still need access to a clinical infrastructure and supply chain.

For this reason, it can make a whole lot of sense for innovative early stage companies to partner with established late stage companies.

The larger company already has all the infrastructure and distribution to produce and sell inventory, but needs new products to sell…

The smaller company has new products to sell, but needs access to infrastructure to start scaling.

But unless the larger company is willing to rent out its infrastructure – like Amazon’s AWS – the smaller company is still stuck with the same problem.

The solution? A strategic investment from the larger company into the smaller one.

The smaller company receives a fresh injection of capital, access to infrastructure, and possibly ongoing advisory services.

The larger company – who is likely looking to fuel growth via mergers and acquisitions – gets to have a “try before you buy” opportunity.

For example, in January 2018, US orthologics company BioVentus made a $2.5 million investment in Israeli medical device company CartiHeal for the development of an ongoing clinical study of its cartilage treatment implant called “Agili-C”.

At the time, BioVentus’s contribution brought the financing round to $21 million, with help from Johnson & Johnson Innovation, Peregrine Ventures, and Elron.

Then, in July, 2020, BioVentus invested an additional $15 million at a $180 million pre-money valuation.

As part of the deal, BioVentus negotiated a call option to fully purchase CartiHeal if Agili-C wins FDA approval.

On August 30th, 2021, BioVentus exercised its option and made a $50 million escrow payment to CartiHeal – signaling its intent to move forward with the acquisition.