John Lonergan: Are VCs Daydreaming Out the IPO Window?

With investments increasing and time until liquidity lengthening to over eight years, medical device venture capitalists are pinning their hopes on a renewed IPO market. But they should be careful what they wish for. IPOs are not coming to the rescue today, nor have they ever been a panacea for VC’s who are deep into a portfolio investment.

Each year, 150 to 190 medical device companies are snapped up by the “BigCos” in the medical device industry: Medtronic, J&J, Abbott, St. Jude and others. In a typical year, only about five of those acquisitions are at valuations north of $100 million. Last year was a bumper year with 17 companies going for 9-digit sums, but this was an anomaly that probably won’t be repeated.

So what’s a medical device venture capitalist to do?

There are two options: continue to pile cash into their companies, hoping that the BigCos see the value and pay the nine figures, or pray for an “IPO window” and hope to bring liquidity and an exit to their LP’s. As we’ve seen above, the first alternative doesn’t look very promising. That leaves the IPO window. But is it really as attractive as many believe?

Let’s take a recent example of a very successful company which spawned a number of similar companies: ConorMed. The company’s breakthrough technology promised drug elution in stents without the use of (or at least lower use of) polymers that cause late stent thrombosis problems for companies like Boston Scientific and J&J. Maverick and Highland Partners were the largest investors, and are to be congratulated for sticking through thick and thin with ConorMed.

We’re now in the area of rumor and supposition, but it appears that ConorMed negotiated with the BigCo’s at a valuation of about $350 million when sale negotiations stalled. ConorMed’s VC investors ponied up additional capital to bring their stents to market it in Europe, and it went public at a valuation of $350 million.

As late-stent thrombosis started to seriously affect the $5 billion drug-eluting stent market, ConorMed’s approach started to look like an attractive portfolio candidate. It later sold to J&J for $1.4 billion, allowing the IPO investors to pocket 4X on their money.

But what happened to the VC investors? They were locked into their stock, and then sold out as soon as they could. Again, this is only supposition, but it looks like $170 million went into a company and $350 million came back. If the VCs had held out and not gone public, they could have pocketed a larger sum. While the IPO was hailed as a vindication of the investment at the time, a 2X (or thereabouts) return on a large, risky investment doesn’t sound like a good bet for most VCs.

So why IPO at all? There are always enough “Google” stories out there to excite LPs’ attention, and it only takes one good IPO to make a (small) VC fund’s investment. As a medical device VC, I believe that my colleagues are holding out the IPO carrot to justify the high amounts of capital they are putting into fewer deals. If only five or so $100 million-plus BigCo acquisitions are done each year, and VC’s are investing tens of millions, something needs to justify the valuations they expect. Hence the wait for the “IPO window.”

So what’s the way out of the IPO trap for medical device VC’s? They may not like the answer. It looks like the BigCos are saying “we’ll buy your company, but not for more than $20 or $30 million.” After all, BigCos are snapping up over 150 such opportunities per year.

In order to return their vaunted 10X returns, VCs can only invest $2 million to $3 million per company. It’s hard for multi-hundred-million dollar medical device VC’s to invest in such small deals. Only the small and nimble investors can play in that sandbox.

So, as an investor, what would I like to have? Restricted stock which is thinly traded, or cash from a BigCo? You answer the question.

John Lonergan is a managing member of Calif.-based Mach Ventures. Opinions expressed here are entirely his own.