Riding Investment Waves

In Pennsylvania, we currently have the modern day equivalent of a gold rush going on in our state (the Marcellus Shale) after the discovery of the country’s largest natural gas deposit.  To get in on the rush, gas exploration companies are offering vast amounts of cash to landowners in exchange for future development rights.  I say future because the economics of natural gas drilling is not yet on par with gasoline, leaving the widespread adoption of the fuel very much in question.  Yet, even with that risk, large exploration companies are willing to spend considerable amounts of money up-front in the hopes that they will receive a handsome payday in the future. 

The economics of natural gas exploration in Pennsylvania is somewhat analogous to that of life sciences product development, wherein investors are willing to spend large amounts of money up-front on the development of life science products, hoping that those products can tap into future markets that are expected to be in the billions of dollars. 

Taking on such risk, whether in natural gas exploration or life science product development, can be daunting for all but the most intrepid entrepreneurs and investors. 

How does one participate in sexy investment trends, such as natural gas exploration, but not take on the risk associated with it? 

The answer is to identify products and services that support those companies working at the bleeding edge of an investment trend.  In the case of natural gas, that means identifying those companies that provide the infrastructure (raw materials) and logistics (housing, food, transportation) that are required by the exploration companies to prospect for gas.  

Like the natural gas industry, there are those life science companies that swing for the fences, identifying new trends and investing big in them, and those companies that provide infrastructure and services to support the homerun approach of their peers (sometimes even these companies can be home runs).  Below is my analysis of two such companies and the products they created to support the development and adoption of bleeding edge technologies.

Avid Radiopharmaceuticals

With an aging US population, the prevalence of Alzheimer’s is growing at an astonishing rate.  Every major drug developer has tried to develop medicines to treat the disease, but with little success.  A key development challenge for drug developers is that Alzheimer’s, especially in its early stages, can be challenging to diagnose.  Poor diagnosis has meant that drug developers have typically sought later stage patients.  These patients are harder to treat as much of the damage done by amyloid aggregates (I am not mentioning tau or prion in this blog post) likely cannot be reversed by therapy alone.  Early diagnosis is therefore a priority of patients, clinicians, and drug developers. 

Avid Radiopharmaceuticals (an Osage portfolio company) has created a radiolabeled ligand that binds to amyloid-beta, a protein that often aggregates in Alzheimers’ patients brains and is considered by many to be a hallmark for the disease.  Unlike drug developers focusing on homerun therapeutics, Avid chose to develop a diagnostic that could aid clinicians in their ability to track disease progression.  While the diagnostic has yet to be approved, Eli Lilly bought Avid for $300 million upfront and is making the company it the cornerstone of its Alzheimer’s drug discovery effort. 

Embrella Cardiovascular

As percutaneous procedures mature and increase in complexity, device companies and clinicians are attempting to insert ever-larger catheters through the arties of patient’s.  Large catheters have a high likelihood of rubbing against artery walls, knocking off plaque and debris that has accumulated on the epithelium.  Once freed, that flotsam may embolize on its passage through the arteries and into the brain where it eventually could cause a stroke.  Early clinical trials for Transcatheter Arotic Valve Implantation (TAVI) procedures in Europe have confirmed the risk of stroke as several patients did, in fact, have strokes.

Embrella Cardiovascular created a simple solution to the floating debris problem; it developed a small net that catches embolisms when inserted into the patient’s heart.  The product is simple to use, relatively cheap, and provides a nifty solution for decreasing TAVI-associated stroke, which could been a stumbling block for the adoption of TAVI procedures.  Being a relatively simple device, Embrella required only $7 million of capital before it was acquired by Edwards Life Sciences for $43 million.

Summary

There will always be those companies that are willing to invest significant up-front resources in risky projects in hopes of generating a substantial future windfall.  What is often less talked about is the role that numerous other companies play in supporting the efforts of those “wildcatters”. 

Adjunctive technologies, when applied to bleeding edge markets, can often generate significant interest from strategic acquirers as those companies seek to build out their product offerings and expertise around a specific development area, such as Alzheimer’s or TAVI.  Identifying trends and products that companies need to better facilitate the development and adoption of core products around a growing trend is a surefire way to start a company that will have significant strategic value to potential acquirers.

Current VC Medtech Investing Trends

Before stopping by the University of Minnesota to check out some of their startup companies, I had the pleasure of attending the 10^th Annual Medtech Investing Conference in Minneapolis.  During the conference there were a bunch of great medical device panels led by VCs, entrepreneurs, and corporate folks.  I thought I might share a couple of interesting subjects that were brought up during those panels and my thoughts on them.

Building to Flip

The build-to-flip concept for medtech startups is something that sounds fantastic but is hard to execute, especially for medical device companies.   The reality is that there aren’t that many ideas that require as little as $5-10 million to develop and can reasonably project a $50-75 million return for investors.  After listening to the various panelists, there are some clear hurdles associated with the build-to-flip model. 

Here are some of the thoughts expressed by the panel:

VC challenges:  Build-to-flip companies require very little capital, which limits the ability for large, and even moderately sized, funds from participating in their financings. 

Funds that are smaller than $50 million can efficiently deploy $5-7 million across 8 investments, but doing so requires each Partner to sit on 4 boards.  Sitting on 4 boards means that in any given week each Partner will have to spend 2-3 days on the road for board meetings, leaving little time for much else (finding new deals, diligence, LP management, etc.).  To limit the distractions produced by board travel and maximize the usage of a small partnership’s time, small funds are typically regionally focused (to make travel less of a time burden) and have an investment niche (to make diligence easier / faster). 

As funds get larger, build-to-flip investments provide considerable bandwidth challenges.  The graph above shows that for a $500 million fund, a Partner will sit on roughly 2.8 boards under normal circumstances, but the number of board seats increases to 5 when the fund starts making a number of build-to-flip investments.  A Partner can theoretically sit on 5 boards in any given fund, but if that large fund goes on to raise another fund then that same Partner will likely need to sit on another 4-5 boards.  No single person can effectively sit on 8-10 boards at any single point in time.  

Another challenge for large funds is that they typically like to lead their deals, and they complete the same amount of diligence regardless size of their intended investment.  Given the same amount of effort required to lead a deal, it is far more time efficient for larger funds to put more capital to work.

Requires tremendous discipline:  Capital efficient companies typically have very tight budget plans and slight delays can have a significant impact on a company’s operations.  Execution risk is a real hurdle for investors as build-to-flip companies are typically single product companies, which means there is no second shot on goal.  Investors have to be very comfortable that there is typically minimal downside protection in a build-to-flip investment.

Cost of doing business:  It costs more to build medical device companies today that it did 10 years ago.  A typical 510k for a run-of-the-mill idea costs at least $20 million, making it challenging for investors and entrepreneurs to identify true build-to-flip product ideas. 

Strategic planning:  Build-to-flip companies typically get to market rather quickly, which is both a blessing and a curse.  Obviously, investors want the product to get to market as fast as possible, but that also means that a lean operation must efficiently change gears from an R&D shop to a commercial enterprise.  Most startups start with an R&D team and then a commercial team (CEO, full-time CFO, VP Sales / Marketing, etc.) is later brought in, but with build-to-flip there is usually little time for such transitions meaning that the initial team must wear multiple hats.  Finding talented managers for build-to-flip companies is no small feat, as capital constrained companies typically do not have the budget flexibility to hire rock star managers.  This creates a considerable execution risk for investors, as the management team must quickly figure out how to sell the product and scale operations with minimal resources.

Need plan B:  When startups are not quickly acquired, management teams often turn their attention to building a sales force and selling their product.  While this may work in select circumstances, the reality is that selling a product takes a lot of money, which most build-to-flip companies do not have.  A suggestion is for build-to-flip companies to work with distributors with an eye towards a structured acquisition.  Such practices do limit future upside potential, but also enhance the chances of investors and management receiving a positive financial outcome.

Attractive investment areas:  Despite boohooing build-to-flip companies, there are some attractive investment areas to pursue.  There are some indications that are bought pre-approval and 510k, such as the Embrella Cardiovascular team, which raised only $9 million and was recently sold to Edwards Lifesciences for $43 million, proving such models can be successfully executed.  Build-to-flip does not necessarily have to be a medical device; it could also be in non-regulated areas, research instrumentation, and services.    

Strategic Investors as VCs    

Strategic investors are quickly becoming the go-to syndication partners for all life science venture capitalists.  With VC dollars in short supply, strategic investors such as SR One, Roche Ventures, Medtronic Ventures, Covidien Ventures, and more, are pumping dollars into early stage companies, even Series A financings.  It is not that these groups are suddenly becoming altruists, but more so that they are concerned that their parent entities will not have hot startups to acquire in the coming years. 

At Osage University Partners, we have felt a substantial uptick in the interest level of strategic VCs in university startups.  Over the last 18 months we have completed 5 life science investments alongside strategic investors.  Below is a chart outlining investments we made alongside strategic VCs, other VCs that participated, and stage of development at the time of our initial investment. 

With strategic investment activity moving at a frenetic pace, it might make sense to stand back for a second and think about what this all means for entrepreneurs, startups, and VCs.

Company benefits: Having a strategic invest in a startup sends a strong validation signal to the market and other potential investors.  Strategics typically focus their diligence efforts on two key areas, the underlying science and intellectual property.  While a VC might only hire a handful of consultants to look under the hood of the science, a strategic can leverage entire R&D groups with deep domain expertise to vet the science.  With regards to intellectual property work, strategics typically have in-house counsel which can provide the startup with “free” pointers on where to shore up the intellectual property.  Scientific and IP consulting work typically costs VCs and the company tens of thousands of dollars, so having it done gratis is a big advantage.

Working with VCs:  For now, it appears as though strategics are more than willing to work with VCs, and view their activity largely as a hedge against a shrinking VC market.  Strategics are negotiating investor and company-friendly deal terms to ensure that they are a welcomed member of the investor syndicate. 

Potential risks:  Investing alongside strategics does come with its risks.  As Mike Carusi of Advanced Technology Ventures noted, having strategics involved in company activities enables them “to see how the sausage is made”.  It is rare that a startup will execute directly on plan, so there is some risk that the strategics will see company missteps that might give them pause when thinking about acquiring the company down the road. 

If the strategic investor does not choose to acquire the company, there is a chance that other potential bidders might get spooked.  To provide some downside protection against such situations and promote an active auction process, VCs have worked hard to create deal structures where the strategic investments come with no strings attached (no Right of First Negotiation, Right of First Refusal, distribution rights, etc).  In the end, with so many strategics investing in life science companies right now, such risks are probably not as large as some might be let to believe.

The medtech world is clearly going through a transition period.  While there have been a number of recent splashy exits by Ardian, CoreValve, and others, the overall number of exits in the medtech space has decreased substantially.  Regulatory burdens have put a damper on sector enthusiasm, and many sector analysts estimate that there will only be 10 PMA approvals in 2011.  Big ideas that can provide serious revenue generation for strategics will continue to be acquired, but build-to-flip and PMA products that address modestly sized markets might struggle to attract capital.  Strategics could fill the funding the gap, but even they have limits to their checkbooks.