How Medical Technology Investing Really Works

In 1993, Dave Stassen was facing a PMA clinical trial for the BAK cage. He was 41 years old. He had been one of the early investors in Spine-Tech. He was a board member and when it became apparent that the company was bleeding cash but not moving forward, he took over, first as CFO then as CEO. Dave, who’d gone to graduate school at a small Minnesota catholic college called St. Thomas and is not otherwise known as a particularly freewheeling risk taker, asked for and got the front seat on the Spine-Tech roller coaster.

The task at hand in 1993 was both survival and forward motion in the form of a PMA clinical trial. There is a reason why 95% of all orthopedic FDA approvals are 510(k)s. They cost less and take mere months to complete. Spine-Tech, which had a $2 million deficit and only about $1.4 million in assets could not use the 510(k) approach and was in no position to pay for a three- to five- year PMA clinical trial.

Spine-Tech’s staff was even less experienced than Stassen. The director of sales had previously sold ergonomic office products. The research and development guy was just 33 years old. But Dave, Doug, Tom and Keith came up with an innovative yet low risk strategy—charge for the BAK cage during the clinical trial. The BAK was implanted in 947 patients aged 21 to 65 all over the United States from 1992-1994. In 1993, Spine-Tech reported $2 million in sales from the clinical trial. In 1994, clinical trial sales were again about $2 million but in Europe, Spine-Tech sold another $2 million to bring overall sales to $4 million—with NO FDA approval.

In 1993, Spine-Tech reported a profit of $12, 000. In 1994, Spine-Tech reported a loss of $379, 000. In 1995 Spine-Tech raised $26 million in an IPO. In 1996, after about 1, 900 BAK’s had been implanted, the FDA approved the BAK for sale in the United States. Gross profits that year reached $7 million.

Question: How risky is a clinical trial that generates profits for the company sponsoring it?

Answer: Not very.

One common perception of medical technology start-up companies is that they’re run by risk taking, brilliant entrepreneurs. There is something heroic about the American entrepreneur.

Seven Keys to Successful Medical Start Up

Actually, when successful medical technology companies are analyzed, their success appears to be less due to the value of the core technology and more about the type management that is running it.

Successful medical technology entrepreneurs:

1. Sell their company eventually to other companies
2. Serve patients that other companies have ignored or missed
3. Shamelessly and repeatedly market their products—if anything they OVER market
4. Employ strong financial controls
5. Never compete on price
6. Prefer to take over an existing business rather than start from scratch
7. Chase DIFFERENT people than their competition (like interventional radiologists instead of surgeons)

A more reliable predictor of medical technology investing success than the technology is the ability of the entrepreneur to manage risk.

Let’s repeat that again. Medical technology investing is less about the technology than it is about incurring the least possible risk to achieve the highest possible return.  

A recent study, “From Predators to Icons” by French scholars Michel Villette and Catherine Vuillermot, was featured in the January 18, 2010 issue of The New Yorker magazine. While they have perhaps an overly jaundiced view of innovation they are absolutely on mark with the idea that the key attribute that separates the successful entrepreneur from the unsuccessful one is the ability to also succeed at risk-minimization. Entrepreneurs who create new markets or industries with their innovations are, if we look back and analyze them, not daring risk takers who revel in bold visionary action but careful and analytical and prone to hedge their bets.

A Structural Hole

Villette and Vuillermot go on to suggest that successful entrepreneurs occupy a “structural hole” or “white space” that gives them a unique perspective on a particular market. They argue, we think, persuasively, that huge gains by entrepreneurs and, by extension, their investors are obtained in circumstances where the entrepreneur, after having spotted the market opportunity, ruthlessly exploits that advantage economically.

In the Spine-Tech case, it was the realization that the intervertebral space was an underutilized implant location for spine fusion (and later non-fusion) procedures to treat degenerative disc disease. That realization spawned a low risk strategy to obtain PMA approval while also attracting a large number of surgeon users via the clinical trial route—and to, in effect, design the studies to be self-paying.

Today an entire sub-industry of intervertebral body implants exists with PEEK cages, bone dowels and disc arthroplasty products. Going into the intervertebral space also opened up minimally invasive spine surgery—which reduced patient complications, hospital time and improved recovery times.

In the case of Kyphon, the structural hole or white space was the realization that vertebral compression fracture treatment was largely a failure. Patients with vertebral compression fractures were almost always elderly with an average of 1.6 co-morbidities each—like diabetes, osteoporosis or heart disease—and in severe pain. The standard treatment of bracing plus pain medication just didn’t work. What’s the value proposition of relieving severe back pain? $5, 000? $25, 000?  $50, 000.

In Europe and to a small extent in the United States, vertebroplasty and the use of bone cement was starting to catch on as a low cost alternative to bracing for vertebral compression fractures. But then the FDA issued a warning about using bone cement in the spine. Enter Kyphon into yet another market white space—the need to create a safe way to deliver bone cement into a vertebral compression fracture.

Like Spine-Tech, Kyphon was also able to exploit a large value disconnect between the cost of the product and the perceived value of the product. Kyphon brought to spine care an inexpensive medical balloon with plastic instruments, which cost, all in, about $400 but could relieve the pain from a vertebral compression fracture. At retail, the market was willing to pay about $4, 500 per patient for the balloon system.

The boldest thing Kyphon’s managers (and more specifically investor Bess Weatherman of Warburg Pincus) ever did was to spend significant amounts of money—not on technology—but on sales hiring and marketing. The Kyphon strategic decision to drive market penetration—even ruthlessly—with a $400 balloon with instruments that delivered clearly superior patient outcomes for $4, 500 was the key to Kyphon’s ultimate success.

Innovation generally but certainly in medical technology is an expensive process that takes a long time to produce profits. In Stassen’s time, a PMA might cost $2 million to  $5 million and take three to six  years. Today, a PMA costs $30 million to $100 million and can take a decade. In Europe, the costs are comparable to the U.S. of the 1990s.

Start Ups Are Less Productive Than Established Firms

A study by economists John Haltiwanger, Julia Lane, and James Spletzer which was published in the American Economic Review Papers and Proceedings used data from the U.S. census and other sources to look at the relationship between company productivity and company age. Their results showed productivity increases with the age of a company.

That means that young firms are generally unproductive and are, on average, poorer stewards of resources than the average existing firm. Poor productivity (wasting money) is why most start-up firms are dead in five years. In orthopedics, the cash machines are DePuy, Zimmer, Stryker, Medtronic’s Sofamor Danek and, at one time, Biomet (before the debt was piled on). The younger, higher sales growth orthopedics companies have profit margins that are a fraction of the larger firms.

Last week we heard the news that Disc Dynamics was closing. Earlier in 2009 IST and Vertebron closed. Other spinal implant companies have also gone by the wayside in recent years. In every case, both professional and such non-professional investors as surgeons lost money. In each case, the level of professional capital invested was in the tens of millions. Did anyone squeeze any nickels? Did the professionals underestimate risk—particularly FDA risk? 

We often hear stories come out of some of today’s more successful small companies like Globus or K2M or Pioneer Surgical of how penny pinching the CEO is. Employees at one of these firms had to pay for a lunch table with their own funds because the founder wouldn’t pay.

So, how does medical technology investing really work? It really works when the guys in charge are cheap bastards who improve patient outcomes with high gross margin products and manage to get through a regulatory process fast. It is both that simple and that difficult.