Diligencing Healthcare Companies, Part II: Problem / Market Size / Solution

Introduction

In Part I of our series on diligencing healthcare companies, we explained that the pitch deck screening and initial call was a way to evaluate the who and the why of the startup. Intuition is key in that initial phase as there are typically not a lot of hard numbers to evaluate from.

Once we’ve moved beyond “fast thinking”, we now need to make sure our intuition is correct. Taking time to exercise slow thinking in evaluating companies is critical because:

1. We believe that numbers tell a story. The stories we learned from our screening calls need numbers to be grounded in reality, and the numbers we ultimately find will create the right narrative that strengthens our investment conviction.

2. Specifically for healthcare, the healthcare industry is made up of many different stakeholders, and making sure the story makes sense for all stakeholders is important. At minimum, companies should consider patients, providers, and payors as broad stakeholder groups.

To aid in our “slow thinking”, we find that having a well-structured, written deal memo is most helpful for this exercise. Why bother to write things out, and write it down?

1. Writing brings clarity of thought, and lays bare what we know and don’t know.

2. Writing stimulates deeper thought and intellectual engagement.

3. It helps communicate our decision with our syndicate members about investment opportunities. (Want access to our deal memos and investment opportunities? Please join our syndicate on AngelList!)

To start our series on deal memo writing, we’ll start with the problem, market sizing, and solution. Again, we try not to be too descriptive about how to write the deal memo, but to express the key points to consider, both from a broad startup perspective, and provide healthcare-specific lines of questioning where appropriate.

Problem: Articulating “The What”

Key takeaway:

All good companies start with solving a problem. Uber started because taxis were hard to get on demand (crazy to think that was less than 15 years ago!); Facebook started because it was difficult to connect with people even within the same school. Having a problem to solve isn’t enough though; not taking the problem at face value, but understanding why it exists in the first place, is critical in understanding whether the company has dug deep enough into this market to have unique insight.

Specific healthcare-oriented questions:

How is the problem perceived at the individual and organizational stakeholder level?

Unless this is a D2C healthcare company, the startup will most likely be selling into healthcare organizations (clinics, hospitals, providers, etc). The startup needs to understand not only what problems the user of their product faces (typically patients and healthcare workers), but also how said problems affects the organizations the users are a part of.

For example, emergency department staff are often overwhelmed with patients, and most solutions proposing to solve patient bottlenecks are welcomed by staff. However, emergency departments are often considered cost centers for hospitals, and investment into ED-based solutions aren’t always viewed with much enthusiasm from hospital management unless solving the problem can significantly increase revenue for the hospital overall.

What’s the current standard of care, and why isn’t it good enough?

Most of healthcare is decidedly not like the TV show House. Since patient care can be sensitive in nature and sometimes involve high risk, healthcare operations tends to be standard of care driven. While these “best practices” doesn’t mean that there isn’t room for improvement, startups will have to clearly articulate how the problem is holding back improvements in multiple areas that standard guidelines cover, including clinical outcome, operational risk, cost considerations, etc.

Market Size: How big is the problem?

Key takeaway

For better or for worse, money is currently the way we value goods and services, and market size is a representation of 1. how the company defines the market, and 2. How much value the outside world assigns to this market. In these instances, a top down calculation from your favorite market research previews work just fine.

At the end of the day, market size is still useful to understand just how much wiggle room this market offers to the company to grow their business, and whether there is enough gold at the end of the rainbow to justify venture outcomes.

Specific healthcare-oriented questions:

How do you define your market?

Healthcare might be worth trillions of dollars, but it actually made up of multiple billion dollar markets of different specialties. In addition, multiple stakeholders are involved in healthcare, and can have different market sizes depending on who pays for your solution. So don’t take numbers presented at face value, whether it be from the company presenting or market reports.

The way I see “market size” is merely a reference for understand whether the true market value that the company is able to capture is reasonable (we will discuss this further in the next post). It wouldn’t make much sense if the company plans on achieving $100M in revenue in 5 years for a market that is only currently $200M in market size right? Unless…

What are tailwinds driving growth in this market?

There may be some key inflection point that will drive growth in this market. Misjudging the market based on what is present may cause you to dismiss potential opportunities too early. The most famous example? “I think there is a world market for maybe five computer”. 

A great example in healthcare is the advent of minimally invasive procedures (TAVR) for heart valve replacement surgery. Originally an open heart procedure only suitable for low surgery risk patients, both open heart and TAVR procedure volumes increased by 30.9% between 2012-2016, driven by a massive 338% growth (13K to 78K) in TAVRs used, as TAVR expanded indication from only patients not suitable for open heart surgery to patients of all risk levels. TAVR is now the predominant method of heart valve replacement and continues to grow a multibillion dollar market at a 10-12% CAGR.

Of course, there are plenty of counter examples given the market crashes of crypto and digital health post COVID of unsustainable tailwinds, but regardless, identifying where growth factors exist that will lead to market expansion is critical.

Solution: what is it, why is it unique, and what is it’s impact?

Key Takeaway:

Beyond understanding what the solution itself is, knowing why exactly this solution unique and defensible is critical, especially in a large and rapidly growing market that is bound to attract copycats.

Specific healthcare-oriented questions:

How does it change patient outcomes?

Unless the company is working on strictly non-clinical problems in healthcare, most healthcare startups will impact patient outcomes in one way or another. Some metrics to look for are:

• Higher survival rate: Will the patient live longer?

• Better quality of life: Will the patient experience improved state of physical, mental and social well-being?

• Less side effects. Most famous example in healthcare? Washing your hands before surgery.

What are the Financial impact to the organization?

As mentioned before, healthcare startups are likely to be selling into healthcare organizations, and without getting into the moral implications of healthcare stakeholders prioritizing economics, the organization’s financial considerations must be taken into account. Does it generate more revenue? Save costs? Some specific ways to impact finances are:

• Reduce Length of Stay: Providers and payors save costs by reducing patient’s time spent at hospitals while still delivering the same or better care. The push towards outpatient procedures by major healthcare stakeholders, where the patient is treated at a provider site without an overnight stay, is a reflection of the financial benefits of reducing length of stay.

• Reduce rehospitalization rates: Broadly speaking, patients making unplanned returns to hospitals after a visit to their provider is due to complications from treatment, so avoiding rehospitalization is not only good for patient outcomes, but also is associated with better hospital operating margins. Specifically, hospitals participating in Medicare will be penalized if patients are readmitted to the hospital within 30 days

• Increased star ratings: Medicare Advantage associated healthcare plans have Star Ratings that impact how much Medicare pays them for providing care. These Star Ratings are calculated based on factors like clinical processes and patient satisfactions. Loss in star ratings are significant enough that major payors will take legal action to protect their star ratings.

An example of a medical product having major clinical and financial impact is Exact Sciences’ OncotypeDx test. While previously recurring breast cancer would be broadly treated with more chemotherapy, the OncotypeDx test demonstrated the ability to figure out which patient would benefit from more chemotherapy, and more importantly, showed that a majority of breast cancer patients actually would not benefit from more therapy. This ability to demonstrate better clinical outcomes in specific breast cancer patient, and also save costs for provider/payors by eliminating ineffective chemotherapy, led to its widespread adoption by payors.

Conclusion: Grounding “The Who and The Why” In Reality

Again referencing Daniel Kahneman book “Thinking, Fast and Slow”, he defined “Thinking Slow” as an approach characterized by more deliberate, logical, and conscious thought processes. The purpose of the deal memo is exactly that: to double check whether our intuition from initial screening is correct. We start with analyzing the problem and solution because it helps us ground the “why” of the startup in reality, and the market size helps confirm that this is a large enough market to build a venture-backable business.

Now that we’ve covered the first part of our deal memo, tune in next week as we cover how we analyze the business potential of the startup, and how they capitalize on their advantages now and in the future. Stay tuned!

If you enjoyed this analysis, share our newsletter with a friend! Every share will bring more people to our mission of improving healthcare.

Ready to put your investing hat on? Please join us at The Healthcare Syndicate on AngelList!