VentureBeat

[NOTE: This is a life-sciences perspective piece by Robin Bellas, a partner at Morgenthaler Ventures. For previous perspective pieces, see here. --D.P.H.]

By ROBIN BELLAS

Does an ebb tide lower all boats? Not when the ship you’re sailing was christened “Medical Devices.” Since the beginning of the year, the Dow Jones Medical Equipment Index of public medtech companies has registered a 13 percent increase in value compared to just a 1.6 percent increase for the Standard & Poor 500 Index. Earlier in the year those two indexes marched upwards in tandem, but began diverging with the onset of general stock market volatility in July.

The continued buoyancy of medical device stocks in the face of broader market storms represents one more victory for this recently enlarged category. Until just a few years ago, public medical device stocks consisted mainly of a handful of large battleships led by Johnson & Johnson, Boston Scientific, Guidant, Medtronic, and St Jude Medical. Since then, they’ve been joined by a flotilla of several dozen smaller companies like Kyphon, Conor MedSystems, Fox Hollow, Insulet, and Masimo. While the former have churned steadily forward, the latter have either gotten acquired at post-IPO multiples of sometimes 4X or more or are speeding ahead independently with annual share growth over 50 percent. No matter what the state of the broader economy, doctors are unlikely to curtail adoption of the more effective treatment of spines, coronary and peripheral arteries, diabetes or neonatal illnesses.

Aside from rapid growth, one of the common characteristics of these smaller medical device companies is that they usually began life backed by venture capital. Their post-IPO performance, unsurprisingly, has attracted even more venture capital — just under $1 billion per quarter in 2007, or 25 percent above last year’s pace. New VC entrants are also flocking to the business; I count a dozen or so new ones in the last year.

Such an investment wave raises the question of sustainability. My guess is that the higher level of investment is here to stay and will even continue to rise. In fact, we may be on the verge of seeing the disappearance of an old venture capital truism — namely, that life-science investment cycles up whenever IT investment cycles down, and vice versa.

Why? Largely because the whole medical device industry has matured. Compare for a moment the performance of medical device stocks during their previous upswelling back in 1996. That rise proved brief and, in retrospect, highly frothy. A few companies with revenues (e.g., Perclose, a Morgenthaler vascular closure company that was ultimately acquired by Abbott for $650 million) did well. Others, however, representing the majority of IPOs at that time, were concept companies like Heartport and CardioThoracic Systems (another Morgenthaler company). Most such companies ultimately failed to live up to expectations.

Investors underestimated the difficulty that concept companies would have in opening new markets. It was a case of not-always-straightforward products aimed at slow-to-adopt physicians. With each unexciting outcome, public investing enthusiasm sank that much lower. Throughout the late 1990s and early 2000s, medical device venture capitalists could only exit by selling companies to the large medtechs. VCs would first identify a product gap in the portfolio of a given medtech, invest in the company developing the new product through proof of concept, then sell. Solid, but nothing worthy of a 21-gun salute!

Look, however, at medical device investing today:

• We’ve got experienced CEOs on their third and fourth startup and more experienced VCs to support them. In short, we’ve got more people who know how to build successful medical device companies.
• We’ve got large, proven device markets like stents and joint replacements. We know that if our companies develop a significantly better product in such markets, physicians are on the lookout for improved patient outcomes.
• Even where our companies are opening new device markets — for instance, fresh approaches to chronic obstructive pulmonary disease such as emphysema — improved technology and the increasingly less invasive nature of the products lead to much faster physician acceptance. It’s common today for a simple, insertable device requiring a one-hour procedure to replace a highly complex, expensive and lengthy surgical procedure. It’s harder to resist change that is easy to implement and improves outcomes while lowering health care costs.
• A number of new devices—e.g. for treatment of obesity, heart disease, glaucoma, etc.– have the potential to achieve the “blockbuster” billion-dollar-revenue status previously attained mainly by Big Pharma.
• Finally, we’ve got far more experienced bankers, analysts and investors who know much better how to evaluate companies and markets. As a result, we have remarkably un-frothy markets which reward companies commensurate to performance, either up or down.

Such facts all add up to a rising tide that can support two distinct VC investing strategies. The most common is late stage device investing, the approach favored by most new VC entrants, but also many established device investors, as well. The rationale is to finance largely proven technology to market and then exit relatively quickly—say, two to three years.

The less common is early stage investing, the one we and a few other VCs prefer and one that capitalizes on our experience at early identification of winning technologies. We think such an approach offers higher returns, albeit within a longer time frame. As our portfolio companies mature, we prefer to use other people’s money for higher-priced later rounds.

We think the rising tide of medical device investing is strong enough to support both strategies. Indeed, as we scan the horizon we only see three small clouds. One is the more recent reluctance of large medtechs to buy young medical device companies early in their development. Instead, they will often wait until the company demonstrates growing revenues and profits. This puts VCs more than ever on their mettle to develop real, fully-staffed companies rather than merely effective technologies.

The second is the increasingly short attention spans of public investors—which, of late, includes many hedge funds. As Thom Gunderson, the able medical device analyst at Piper, Jaffray likes to put it, “it used to be that a long-term investor would check his portfolio every quarter. Now it’s every five minutes.” This fact of investment life has led to increased volatility for device company stocks, especially those that are still pre-revenue. Such volatility can threaten to put further financing for such costly activities as U.S. clinical trials, at least temporarily, under water.

Finally and third, some areas of medical device investing like obesity, artificial spinal disks and neural stimulation seem to be attracting the kind of over-investment that leads to widespread company failures. We think such situations can be avoided by investing early in large markets capable of supporting several winners and by picking projects that offer faster clinical endpoints.

Overall, however, these clouds seem unlikely to expand into storms that bring unmanageable turbulence. The quality of and demand for better medical devices is just too strong. For the foreseeable future in medical device investing, we expect “fair winds and following seas.”

Robin Bellas, a former nuclear submariner, continually scans the horizon for new medical device deals. He is a partner at Morgenthaler Ventures in Menlo Park, Calif.

[NOTE: This is a life-science perspective piece by Vance Vanier, a Stanford physician and a partner at Mohr Davidow Ventures. For previous perspective pieces, click here. --D.P.H.]

By VANCE VANIER

Katherine is a 35 year old experiencing fatigue, tingling in her hands, and visual problems. She made an appointment with her doctor, arrived with a stack of online health site print-outs, and announced that she had diagnosed her problem as a relatively rare pituitary tumor. She was right.

Such encounters are becoming more commonplace among physicians, and they are met with mixed feelings. When patients educate themselves with materials from trusted and reputable sources, these encounters lead to good discussions. In other cases, physicians get frustrated because patients may delay treatment due to misinformation online. Most importantly, however, these encounters are a harbinger of profound change in the way patients relate to their doctors and the healthcare system as a whole. A set of new technologies is empowering patients to understand and manage their care in a manner that changes the healthcare paradigm. Call it Health 2.0.

Health 2.0 in many ways follows the Internet paradigm shift from Web 1.0 to Web 2.0. In the Web 1.0 model, content, tools, and communication online often came from one centralized authoritative source with little user feedback. Web 2.0 sites, however, renounce these top-down models. Online users actively participate in generating their own content for sites and then sharing it in communities of other users.

The practice of medicine has been entrenched in the 1.0 model. Medical knowledge and the delivery of medical expertise to treat the sick has been the province of a chosen and authoritative few. Until recently, patients have largely depended on individual doctors to provide information and monitor their illness. However, there are early signs of change that suggest a shift from the 1.0 to 2.0 paradigm in healthcare. For example, there has been a rise of decentralized user-generated content in the form of wikis, blogs, and patient community social networks. According to a survey by Manhattan Research, 9.9 million consumers regularly post health information online and learn from each other.

In addition to learning from their peers, patients like Katherine are increasingly seeking information online before they visit their doctor. In a recent Harris Poll of 1010 adults surveyed in July of this year, more than 70% had looked for health information. In the near future consumers will have an even greater understanding of their health as search engines advance to take into account patients’ personal health histories–currently the exclusive domain of human physicians. Enabling this change are dozens of companies offering consumers the ability to store and manage their own personal health records as opposed to depending on their health providers for their records.

Further change is coming in the management and monitoring of patients’ chronic health conditions. In recent years, managing chronic diseases such as diabetes and depression has gradually moved from the doctor’s office to disease management companies where nurses in call centers issue frequent phone calls to patients to remind them to perform specific actions. However, some chronically ill patients can now find websites with communities of similar people exchanging information, reassurances, and practical advice. Through these new sites patients are getting more tools to monitor their conditions from home and get real time feedback that can lead to positive behavior change or earlier intervention.

For example, a preliminary study using remote monitoring devices and the Internet for patients with diabetes in underserved Medicare populations in New York State showed health outcome improvements. Remote monitoring devices tracked blood pressure and blood levels, allowing providers to easily monitor patients. Results from this study have shown patients improvement in hemoglobin, blood pressure and cholesterol levels. In addition, tools as simple as Internet enabled electronic scales that detect early weight gain can empower congestive heart failure patients to collaborate with their doctor and seek changes in medication to avoid hospitalization.

While the concepts of Health 2.0 are promising, it is still early days and there are clearly challenges to be met. For instance, user generated content while appealing to some patients has drawbacks such as the potential to generate misinformation and confusion rather than answers grounded in scientific fact. Putting health records in patients’ hands puts the onus on individuals to keep them up to date, not to mention secure and private. Not all patients want reassurance from peer networks and may prefer physician guidance instead. Though these challenges are real and complex, there are compelling aspects to the Health 2.0 shift that may have the potential to improve the lives and medical care of patients like Katherine.

Some of the nation’s leading thinkers, entrepreneurs, executives, and healthcare providers are discussing these issues at the Health 2.0 Conference today. Visit www.health2con.com for details.

Vance Vanier, M.D,. is an attending physician at Stanford Hospital and a Partner at MDV- Mohr Davidow Ventures.

[NOTE: This article inaugurates our “Perspective” feature, in which entrepreneurs, investors, and other experts discuss developments or pressing issues within the life sciences -- a parallel effort to the "Contributors" section on the main VentureBeat page. We ultimately hope to distinguish perspective pieces from our regular coverage with a distinctive font and other visual elements, but for now, they'll just be labeled clearly and will carry a note much like this one. --D.P.H.]

By SERGIO GARCIA and MICHAEL DAVIS-WILSON

Earlier this year, the Supreme Court shook the foundations of patent licensing and technology transfer, altering the balance of power between patent holders and their licensees and creating profound implications for the life-sciences industry. In MedImmune v. Genentech, the high court effectively paved the way for more frequent patent challenges that could disadvantage smaller companies and organizations.

For decades prior to the MedImmune decision, courts typically refused to allow a company that licensed a patent to challenge its validity unless that company had violated the license and faced an imminent lawsuit for infringing the patent. In MedImmune, however, the Supreme Court ruled that licensees shouldn’t have to risk the harsh consequences of an infringement suit in order to ask a court to invalidate a patent. (Read the court’s Jan. 9 decision in PDF form here.)

Now companies that license intellectual property are much freer to challenge patents, a development that has already begun to alter the playing field for patent holders and licensees alike. That’s particularly true in industries such as biotechnology, where widely licensed patents that cover drug-production technologies are commonplace. Early indications based on lower court decisions also suggest that MedImmune may have made it easier to challenge patents in a broad variety of circumstances, not simply those in which a company wishes to avoid paying royalties by invalidating a licensed patent.

The post-MedImmune environment presents an acute challenge for small biotech companies and universities. These organizations generally have limited funds to fight patent lawsuits and might therefore face stepped-up legal attacks on their patents. Some licensing strategies, however, can help minimize those risks, although none are quick fixes, and their effectiveness will vary depending on the relative bargaining power of the parties involved.

IP holders, for instance, may seek to make patent lawsuits more expensive for licensees by requiring higher royalties, or even termination of the license, in the event of a challenge. In the latter case, of course, a challenge could once again expose the plaintiff to an infringement lawsuit, effectively restoring the pre-MedImmune status quo.

Patent holders might also seek to reduce the economic incentive to challenge a patent by “front-loading” payments — for instance, by requiring a lump-sum payment at the time of signing in lieu of a high royalty rate on potential future sales of products covered by the license. Finally, licensing companies may erect new roadblocks, such as making mandatory arbitration of any patent challenge a requirement of the initial license agreement.

Of course, many patent holders, especially emerging companies with limited resources, may not have the bargaining clout to insist on such terms. What’s more, these strategies will only work for future licenses — current licenses will remain vulnerable to challenge under MedImmune unless they are renegotiated.

In many respects, MedImmune has substantially boosted the risks faced by patent holders while creating new leverage for licensees. In this sense, it parallels other recent court rulings and new patent-office rules that also threaten to erode patent protection. While well entrenched patent holders may be able to limit those risks by altering the terms of future licenses, there remains a strong possibility that the new legal environment could limit the ability of smaller companies and universities to make full use of their intellectual property, potentially even jeopardizing the pace of biomedical innovation.

Sergio Garcia is a partner in the Intellectual Property Group and the Corporate Group at the law firm Fenwick & West. Michael Davis-Wilson, a Fenwick & West summer associate, contributed to the preparation of this article. Disclosure: Fenwick & West is a sponsor of VentureBeat.