Health-Care Investors Continue Adjustment

Once the investment darling of the early ’90s and now a casualty of changing preferences, health-care plays have been left lying next to MC Hammer albums as forgotten habits of the past. But like Hammer, some determined health-care principals are trying to find ways to readjust to the realities of their audience, and – while it is unlikely these VCs will take up preaching – they are being forced to find religion in a new world.

“The [health-care] model is broken in terms of VCs needs and the reality of what is going on,” says Mike Carusi, an Advanced Technology Ventures principal.

What has rent the model is the increasing pressure for early returns that LPs are placing on firms. This pressure emanates from the increasingly shorter maturation process for Internet companies that shower LPs with outsized returns, while health-care companies must plod through regulatory minefields where they have no control over the time devoted to the effort.

The first effect of the changing landscape is the reluctance of venture firms to back early-stage health-care concepts, be they devices or pharmaceuticals. Sources throughout the market agree that unless a new health-care concept fills a gaping hole in the service sector to a larger market, it is hard to justify the extended funding process that is required to reach the promised land.

“Companies used to be able to just prove the technology and start Phase I testing to go public,” says Damion Wicker, general partner at Chase Capital Partners. “Now the public markets require less risk, so companies have to go further into trials [before looking to an IPO].”

Due to this, those companies that do get funded either bring to the VC a mature product that is well into clinical testing or have already gone public and need one more round of capital to finish tests.

Late-stage companies increasingly bring more substantial offerings to venture investors than they have seen in some time. These substantive offerings include more developed business plans, or redirection into new markets that are more attractive to VCs than a company’s original revenue model may have been.

Witness the fifth-round financing of LXN Corp., a San Diego-based company that is developing self-testing products for diabetes sufferers (PEW May 10, p. 9). Following its fourth round in late 1997, the company planned to go public last year with its first product, which targeted institutional customers. With the IPO window shut for biotech companies, the company launched development of its consumer product that in turn attracted lead investor MPM Asset Management to the most recent round.

“We are investing in the commercial product because that is where the real value for the company will come from,” MPM Managing Director Ansbert Gadicke said at the time.

Public companies that pursue PIPE transactions bring tremendous value opportunities to investors. These companies, which went public early in their growth cycles, have been driven back to the private market, generally as a result of missing earnings or misjudging the time needed to complete clinical trials and leaving themselves cash-strapped.

“When you look at a company like Healthsouth, which is essentially the Microsoft of health-care services, and compare [ its valuation] to where it was, there are outstanding values,” says Scott Meadow, a partner at The Sprout Group.

What’s a Company To Do?

Obviously, given these new investment-decision drivers, entrepreneurs need to bring a fresh menu of offerings to the table. Regardless of the stage of the company, investors are looking for large plays, and the path to an exit must be readily visible.

Early-stage companies that do get funded need to be “home-runs,” venture sources say. ATV’s Carusi says ancillary projects simply will not attract seed capital in this environment, but he hastens to add that his firm will continue investing in early-stage companies that have meaningful ideas.

“The dynamic comes back to liquidity, where you don’t want to load up on either end stage,” Carusi says. “There has to be a balance with late-stage deals that afford a clearer path to earnings.”

To be sure, this does not leave late-stage companies in the driver’s seat when they come to market with new rounds. Sprout’s Meadow says that his firm wants to put larger amounts of capital to work in companies that offer a unique service. Furthermore, there is uniform agreement that companies need to cultivate products that serve a large market and answer a pressing need – cancer, cardiac care and neuro-care were those mentioned most often.

These difficulties then raise another, troubling question: Where does the next run of health-care companies come from?

Carusi cites the increased presence of corporate venture arms as a good omen for future programs. These giants acknowledge the need to preserve the new-product pipeline, and they fund VC divisions that are mandated to encourage entrepreneurial development. An incentive to these efforts is that while encouraging start-ups, it enables them to keep a watchful eye out for the next big idea.

“Companies know that if the [venture capital] pipe runs dry, the corporate partners will find a way to fund the product,” Carusi says.

Also serving as a means to an end for new development is the increasing occurrence of corporations spinning off divisions that may have non-core products with strong potential. A case in point is the recent divestment of Circe Biomedical Inc. by W.R. Grace (PEW April 19, p. 1). Six venture firms jumped at the opportunity to back the company, which is in pivotal Phase II/III trials, and the shortened time frame to commercialization enamored investors.

“This kind of environment applies a tough discipline that will probably make for better investing,” Meadow says.