The Funding Paradox for Orthopedic Startups

• Updated on: 2018-04-03
• Read original article here

I often talk with leaders of early innovative startups and hear this complaint.   What is going on here?

The Big 5 Orthos, commonly referred to as the “strategics”, have mountains of cash. Their biggest asset is their distribution channels.  So, you would think that they would look for ways to feed their distribution channel with new products, increase their top line and keep the shareholders happy. After all, we all know that new products open doors to compete with entrenched competitors. New products give the sales person a reason to go back and see the surgeon who is loyal to the competition. And new products bring positive attention to the company.

The Big 5 have chosen not to innovate from within, so they have to buy innovation. Their management does not incentivize employees to do new stuff. It’s cheaper in their minds to pay more for a later, de-risked deal. The finance people running the these companies seem to avoid R&D expenses that ding earnings and share value. A company turning over EBITA has become the golden age of private equity. The problem with the Bigs taking in smaller stuff are the rendition costs, especially upgrading a quality system in a small lean operation to the level a major has to operate at. This quality and regulatory bar will get higher with the new CE Mark rules over the next 2 years.

But if you understand what the majors are looking for, then you can reverse-engineer that back into an opportunity they will find attractive. They are the “strategic acquirer customer” who will give you liquidity. You have to understand this “customer” perspective just as well as you understand your clinical customer. You have to know their needs, be able to build to those needs, and have a trust relationship.

So why don’t the Big 5 simply buy technology innovation startups? Problem#1 – The Big 5 do NOT want to buy TECHNOLOGY At the Canaccord meeting ahead of AAOS this year, the Big 5 spelled out exactly what they were shopping for – sales.  They readily admit that they are not looking to acquire technology, but to acquire new customers. “Bring us $8M or more of revenues and we may be interested.” Here is the dilemma  For a cash-strapped innovation startup to reach $8M, they have to spend more than 50% of their capital on sales & marketing, not product.  These days, even for $8M in sales, it takes a real sales presence to penetrate the Integrated Health Networks (IHN).  For a innovative technology startup, building a sales channel is misuse of capital. Problem #2 – The Big 5 do NOT want to buy RISK They have become so risk averse, that they are only interested in startups that have adequately retired the technology risk, retired the regulatory risk, retired the reimbursement risk, and have proven sales.  In other words, enough real customers are paying handsomely for the new innovative product.

Well, as a general rule today, the VCs are only funding investments that fit into their profile and they are generally looking at later stage startups. Also, VCs are not your friend and you must be very careful in partnering with them. My favorite quote about VCs rings true…  “VCs are like hitchhikers with credit cards. They get in your car, and as long as you take them where they want to go, they will help pay for the gas. But if you get lost or wander off the road you promised you were going down, they will hijack the car, throw you out and bring in a new driver.” John Mackey, Founder of Whole Foods.

The Angels are a good fit for you.  Today, the Angels are really the only ones funding early innovation, but there just are not enough Angels to fill the need.  And there is a huge gap between the seed stage capital and growth stage capital.  This gap has been referred to as the “Valley of Death” because many startups do not survive this chasm. A new positive trend in early stage capital is the syndicated Angel deal. Orthopedic startups are hitting angel groups that have multiple chapters, or syndicating across multiple Angel groups to piece together the the sort of capital raises that the smaller (now extinct) VCs used to do. These Angels are now the most active early stage investors, but they cannot fund everyone.

So, we can see that there are funding challenges with the Bigs, the VCs and the Angels. Unfortunately, the end result is that there is scarce funding for truly innovative startups in orthopedics today. So what is an orthopedic startup with a great idea to do?