Venture debt can be a good option to fund medical device technology

Venture debt has long been a favored source of non-dilutive capital amongst life science companies, particularly medical device companies. Why?

Venture capital investing in medical devices and diagnostics has traditionally lagged biotech by more than half, says Justin McDonie, senior vice president and managing director at Bridge Bank.

“Total venture funding for medical device companies declined following the 2008 recession and never recovered, even as funding has rebounded elsewhere,” McDonie says.

According to a recent MoneyTree Report by PricewaterhouseCoopers (PWC), a total of $2.8 billion was invested by venture capitalists in medical devices and diagnostics in 2015. That’s the highest annual sum for medical device and diagnostic venture investments since 2008.

However, investments in this sector are poised for another down year with $1.1 billion invested across 119 deals through the first six months of 2016. Compare this to biotech with $3.7 billion invested across 224 deals for the same six-month period.

“While medical device development follows a well-established development path, the length of time required for 510(k) clearance and PMA approval has increased,” McDonie says. “According to a Stanford University report, it’s estimated that the average cost to bring a low-to-moderate 510(k) product from concept to market is $31 million, while high-risk PMA costs average $94 million.”

Smart Business spoke with McDonie about how the lack of venture capital dollars for medical device companies creates opportunities for venture debt to augment venture capital dollars to fund medical device technologies.

What other factors have driven the investment disparity between medical devices and biotech?
There is a lot of reimbursement uncertainty in the U.S. In addition, under the Affordable Care Act (ACA), a new medical device excise tax was enacted which is a 2.3 percent tax on revenue for device manufacturers. That’s a pretty regressive policy.

The tax is under a moratorium for two years, but in terms of the venture capital view, and because it is viewed as regressive, it’s a tax that hampers the cash flow of cash-burning startups and thereby hinders the length of time that a VC firm has to recoup its investment dollars.

Several venture capital firms have said they’re not going to invest in medical devices anymore or have pivoted towards investing in later-stage device opportunities where there is a clear reimbursement pathway and shorter exit horizon.

Investors are not willing to spend tens of millions of dollars fighting a reimbursement battle. If you look at biotech valuations versus medical device valuations and the multiples on return, those multiples are significantly less for medical devices than biotech.

With the uncertainty in the reimbursement world as it relates to devices, coupled with the lack of venture dollars and LP dollars that are allocated to device venture funds, funds have either turned toward biotech only or later stage medical device or health care services.

What is the key to maximizing the value of venture debt?
You need to be clear about the problem you are trying to solve by adding leverage to your balance sheet. Is it pure balance sheet bolstering for a company that might be entering into strategic negotiations? Or is it bolting on capital that is going to provide runway extension?

Often, venture debt is funded alongside an equity component; you can augment with equity to reach the same financing target, allowing VC’s to keep more equity dollars on reserve should future funds be needed. For example, and for the sake of simple math, if a company raises $12 million and is burning $1 million a month, it will have 12 months of runway.

A $6 million debt deal is going to provide that company an additional six months of runway. For a commercial stage company, that six months could be very meaningful as further revenue growth could drive a higher valuation at the next equity raise.

There are various development milestones where debt can play a meaningful role in helping companies reach critical inflection points in a non-dilutive fashion, such as PMA approval or 510(k) clearance. The key is to understand the value of venture debt and be clear about what it gets you without over leveraging your business. It has to buy you something meaningful. Otherwise, there is no point in doing it.

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