Diligencing Healthcare Companies, Part III: Evaluating the business opportunity

Introduction

In Part II of our series on diligencing healthcare companies, we explained that taking the time to write a deal memo was a great way to ground our intuition in reality. We began by evaluating "the who and the why" to understand why the company even exists in the first place.

However, a mountain of gold is worth nothing if you can’t figure out how to mine from it, so now we evaluate how the startup goes about capitalizing on the business opportunity to create financial value.

Without further ado, let's go gold mining!

Go To Market Strategy: Who’s your first customer?

Key takeaway

“0% of a billion dollar market is worth 0 dollars”, as my mentors are fond of saying. Selling is hard, after all, and even a company at the earliest stages should be thinking about who within their Total Addressable Market will be the first to uptake their product, and how exactly they will reach them.

Specific Healthcare-oriented questions:

Who are your Initial User Profiles?

Healthcare has alot of stakeholders. Even within a particular stakeholder group, there are many different subgroups that have different needs and desires. Taking sleep apnea patients for example, a young person that travels very often will be in the market for a portable CPAP, versus an elderly patient who tend to have dry mouth and would need a humidifier to deal with dry mouth, and a well-designed hose to prevent trips and falls when getting in and out of bed.

Getting as granular as possible, and understanding what the unique challenges are for that particular type of healthcare stakeholder is critical.

How do you reach and educate these customers about your product?

Often times with novel products, selling to customers is actually the second thing to do; educating customers about the problem and solution is the critical first step to getting patients to build awareness around your solution. Healthcare is very much built on trust, and establishing that connection with stakeholders is crucial for any healthcare startups.

Each stakeholder acquires information differently, and care about different elements of the same information as well. For example, patients might care about ease of use of a medical product, while physicians care about clinical outcomes, and payors care about cost savings.

What other stakeholders along the customer journey has a say in how the product gets to the user?

The healthcare market is unique in that the user (patient), the decision maker (provider), and the person that pays (insurance) aren’t the same people, unlike most other market verticals. As such, startups need to care not just about what the end customer will do with their product, but also who else influences the purchasing decision. The simplest example is a prescription product will require buy in from the physician to prescribe the product.

In addition, the way medical products are distributed means there are non-medical personnel that hold the keys to distribution that needs to be taken into account. For example, sleep apnea has stakeholders in Durable Medical Equipment (DME) distributors that are responsible for distributing CPAPs, getting patients setup, and tracking compliance for reimbursement. In this instance, companies in the sleep apnea space needs to also consider how they would motivate DMEs to carry their products.

Business model: How will you charge customers?

Key Takeaway:

We already have an idea of the market size from a top down level from the market size section. Now, the goal here is to build up a bottoms up calculation of the market. (unit economics * number of people that fit the initial user profile)

Why is it important to look at the market size from a different angle? It’s easy to cite a trillion dollar total addressable market in healthcare, but as we mentioned before, healthcare is not a homogenous trillion dollar market, but rather made up of hundreds of smaller billion dollar market verticals. Subdivide the verticals into their various stakeholders as we defined previously in the go to market strategy section, and one might find that the initial market isn’t big enough (ideally >$1B) for a venture return.

Specific Healthcare-oriented questions:

What are the unit economics of your business model?

Are you selling directly to patients? As a prescription product through payors/providers? Or through employer benefits? Based on who the target customer is, the company needs to pick the right monetization method that fits how the customer typically operates. Here’s a few models that are common to the healthcare industry, and what startups do to create financial value:

1. Fee-for-Service (FFS): Most commonly seen in medical devices and diagnostic companies selling physical to providers, healthcare providers are paid by payors based on the number and type of services they deliver. Here, the unit economics come from acquisition pricing that ensures enough margins for all parties involved in the acquisition.

2. Per Member Per Month (PMPM): Most commonly seen in digital health companies selling to employers/providers/payors, the companies charge their customers a fixed fee per enrolled patient per month regardless of how many or few services that patient uses.

3. Value-Based Care (VBC): In this model, providers are reimbursed based on the quality and effectiveness of the care they provide, measured through patient health outcomes. For companies, the unit economics are typically based on a base pricing per member covered by the company’s services, plus a percentage of savings captured by the payor/provider that will be shared with the company.

What’s the basis for charging what they do?

Unless the company is pursuing a 100% self pay model (concierge primary care like Forward Health or D2C companies like Hims), healthcare pricing tends not to be dictated only by market supply/demand, but also existing reimbursement landscape and health economic analysis. Following the categories above, how should companies decide how much to charge?

1. Fee-for-Service (FFS): Pricing is typically based how much payor reimburses per use of their product. Companies will either have to prove that existing reimbursement codes cover their product, or apply for a new or supplemental code.

2. Per Member Per Month (PMPM): This fee is calculated based on historical healthcare utilization rates, demographic factors of the patient population (age, health conditions), and projected costs of care.

3. Value-Based Care (VBC): Pricing in VBC models is closely tied to the achievement of specific health outcomes and cost-efficiency metrics. Pricing strategies might include shared savings programs, where startups share in the savings generated from efficient care, or bundled payments, where a single price covers all services related to a treatment episode.

Traction: What makes them the fastest horse?

Key Takeaway:

Problems in healthcare are usually known (“a certain disease makes people sick”), and have commonly desired outcomes (“people need to be rid of the disease”), so any lucrative problems will have multiple companies chasing the same outcome. The point isn’t just to know how far along they are in the journey to the outcome through typical metrics like revenue, but also to understand why they are fundamentally able to get to where they are with typically limited resources, and how they can build an edge by going on this journey compared to their peers.

Specific Healthcare-oriented questions:

What FDA classification is your device?

If a startup is developing a medical device (can be both hardware and digital based), chances are they will have to get FDA approval in one of these categories:

1. Class I Devices: These are low-risk devices and typically include non-invasive products such as elastic bandages, examination gloves, and hand-held surgical instruments. Most Class I devices are exempt from only need to be registered with the FDA, but still must adhere to general controls like good manufacturing practices.

2. 510(k) Clearance: This process is applicable to moderate-risk devices that are substantially equivalent to a legally marketed device (predicate device). An example of a device that would require 510(k) clearance is a digital thermometer or electrical wheelchairs. Manufacturers must demonstrate that their new device is as safe and effective as an existing device.

   Most startups will attempt to develop medical products in this category to bring to life new innovation while balancing speed and risk to entering the market.

3. 510(k) De Novo: This pathway is used when no predicate device exists, allowing a new and novel low to moderate-risk device to enter the market. An example might include a new type of non-invasive glucose monitor that employs a novel technology not previously classified under existing codes.

   The key here is that the FDA holds the power to decide whether a startup’s product can go through the De Novo process, or be elevated to a Class III device process, so startups need to work with the FDA early to ensure they will be considered for this pathway.

4. Class III Devices: These high-risk devices usually sustain or support life, are implanted, or present potential unreasonable risk of illness or injury. Examples of Class III devices include implantable pacemakers and heart valves. These require premarket approval (PMA), demonstrating safety and effectiveness through clinical trials.

   You’ll find that even most healthcare investors will shy away from investing in Class III devices given the heavy financial investment needed to run multiple trials, but surprisingly, Class III devices can actually yield better venture exit results than 510K devices. [LINK HERE]

5. (Bonus) Breakthrough Device Designation: This designation is granted to certain medical devices that provide more effective treatment or diagnosis of life-threatening or irreversibly debilitating diseases. Companies will still have to go through 1 of the 4 submission processes above, but this designation facilitates a faster pathway through closer and more frequent interaction with the FDA during the device development process.

Tactically, most startups will engage consultants or lawyers who have either worked for the FDA, or have a track record of successful submission. You’ll rarely see a company attempt to do this submission by themselves.

What work have they done to convert technology into a real product?

Healthcare companies with a core technology are typically lead by scientific cofounders, and have been working on their technology for many many years, The biggest mistake I see is that they assume that the technology is easy to use for customers as it was for them, forgetting that:

1. Customers are not familiar with the underlying technology like they are

2. The customers have a lower tolerance for a protracted learning curve.

Forgetting to consider customer preference will derail most commercialization efforts.

In fact, human factors engineering is a whole discipline in itself, and becoming increasingly asked for by the FDA as part of the submission process.

Future Roadmap: Where are they headed?

Key Takeaway:

Companies never grow exponentially forever, not even the most enticing early-stage companies working on the hottest, largest markets.

Even the most successful decacorns of our era didn't achieve their status through a single, exponential growth curve.

Facebook had Social Graphs, Google had AdWords, Amazon had AWS.

Their seemingly exponential growth is more accurately described as a series of stacking logistic curves, with each curve representing new opportunities.

So be on the lookout for companies who can clearly articulate what additional services they can uniquely develop from their initial product.

Specific Healthcare-oriented questions:

What behaviors do you need to consider beyond curing/managing their disease?

Much of healthcare is alot about managing behavior change, so understanding how customers change the way they do things because of a disease is important. Especially with lifestyle diseases (Diabetes, Cardiovascular Disease, etc) becoming leading causes of death, chronic conditions now demand companies to provide solutions for challenges patients face directly AND indirectly because of the disease.

For example, healthcare unicorn Omada Health not only manages diabetes and heart disease for patients, but also integrates personalized coaching to improve their lifestyle choice, and provides connected medical devices (BP cuffs, glucose monitors) to measure patient vitals, all in an effort to serve every need of a diabetic/cardiovascular patient.

Competition: Why does this horse give me the best odds?

Key Takeaway:

While we covered the reasons why the company has a compelling solution in the previous article, startups obviously don’t exist in a vacuum. They will be competing with incumbent, existing innovators, and future competitors. Here, looking at non-technical advantages is just as important as understanding technical advantages.

Specific Healthcare-oriented questions:

Could a technically inferior product serve their customers better?

The reason why we frame this question in this way is to understand what other factors influence the customer’s buying decision. The more the company understand those factors, the better equipped they will be differentiate from the pack.

A well known healthcare example would be Clear Aligners from Invisalign. While traditional braces often provide more forceful and precise teeth movement, making them suitable for more complex dental corrections, Invisalign offered a solution that addressed significant customer needs around aesthetics and comfort.

Does someone else have a distribution advantage?

Outside of Healthcare, this is the strongest demonstration of distribution advantage:

As mentioned in the go to market strategy, there may be other healthcare stakeholders (physicians, DMEs) outside of the product’s users that may control how a medical device/digital product is distributed. It is important to understand whether the company has managed to sidestep this potential bottleneck by creating a new channel, or figured out how to be competitive in the same sales channel.

Conclusion: Answering “The How”

Ultimately, one of the goal of any for-profit company is to make money. With that in mind, we've dug deeper into how startups capitalize on their opportunities to create real financial value.

If we describe this section of exploiting the business opportunity as mining a mountain of gold, our job is to find out how far they are along their business journey.

Are they just getting their hiking boots? Got their picks and axes? Have they dug tunnels, put the support beams in? Have they already started shoveling out dirt to sift for gold?

Just as miners need the right tools and maps to extract gold from a mountain, startups need robust strategies in GTM, business modeling, and competitive landscaping to mine the considerable value from their markets. Properly evaluating how much the company has planned out their monetization strategy will help us understand whether the company has real commercial potential, or a cool science project still finding its way.

Now that we’ve covered the second part of our deal memo, tune in next week as we wrap up the series on diligencing healthcare companies by analyzing how we tie all our analysis back to “The Who”, and how investors can generate a return from their investment. Stay tuned!

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