In defense of tech-enabled services
Why we remain bullish on services, even as the market has shifted to favor software
U.S. digital health funding hit an all-time high at $29.1 billion in 2021 – or approximately 8.8% of the total U.S. venture capital investment. But there’s no doubt that 2022 is a very different year.
With health-tech companies taking a beating in the public markets, there’s been a lot of questions about the “investability” of the sector. Every day when we read the news, we hear about companies sharing layoff announcements and struggles to raise follow-on rounds. And given that health-tech is still relatively nascent, there are fewer examples to point to of long-term success in the public markets.
With this uncertain macroeconomic backdrop, the debate we hear often in the VC world is essentially this: Software versus Services. In other words: Is the optimal pathway to making a return in health care and improving the lives of patients, providers, and other stakeholders to invest in software, or services made more efficient by software?
It’s not surprising. SaaS companies tend to be favored by investors during economic downturns because they are viewed as more stable, better understood, and cheaper/faster to scale. We’re excited to see some great companies emerge here too - and some of our funds (Flare Capital Partners, OMERS Ventures, 7wire Ventures, and Vive Collective) have already made bets. But we’re here to argue that tech-enabled services shouldn’t be neglected.
In fact, it’s our view that services will remain the dominant business model for some time, and represent the largest addressable markets in healthcare. Some of the largest digital health exits of our time were tech-enabled services companies, such as Livongo on one end of the spectrum with its primarily hardware/software product and some coaching services, and One Medical on the other end with services and clinics enabled by technology.
But first, let’s clarify what we mean when we talk about services…
“Services” comes in many shapes and forms
So-called “services” is a catch all term that refers to many things. Off the top of our collective heads, there are data aggregation services, data normalization services, analytics-as-a-service (e.g., population health analytic, network analytics, actuarial analytics), payer/provider contract services, network management services, provider practice management services, clinical documentation and risk adjustment services, other management services organization (MSO) services, software-implementation services, care-related services and more. Phew!
For the purposes of this piece, we are focusing on services that heavily involve people in the design and delivery of the product, and specifically the type of people who provide care to an individual patient or population. That tech-enabled service could be virtual or via a “brick and mortar” experience.
Within that, there’s a full spectrum of ways that companies can be reimbursed for providing services ranging from Fee for Service to taking on full risk or contracting directly as part of benefit design, which we’ll discuss in more detail. Some of these models are giving companies opportunities to meaningfully innovate on traditional care models without worrying about getting reimbursed for each service provided.
Now that we’ve got the definition out of the way, here’s a bunch of reasons why we’re bullish…
A lot of companies start in SaaS and move to services…
We often see SaaS founders pivot when they realize deeply impacting the care model at scale and speed requires participating in the human touch inherent to healthcare, and experience the product stickiness of the provider-patient relationship.
One example of that is in the remote patient monitoring (RPM) space, which involves using technology to gather health data on patients and take care of them outside of the four walls of the clinic. Many companies begin with SaaS - by selling the technology to provider groups - and end up employing or contracting teams of care coordinators and nurses to handle everything from patient onboarding to ongoing care monitoring. That often happens because the buyer doesn’t have the capacity on their end to make the most out of the tool, so the engagement and utility trails off. A few of these companies have even decided that it makes the most sense to take on the care model and become a verticalized provider themselves, fully owning the patient relationship and reimbursed directly by health plans.
That brings us to another reason why software-only approaches can be less attractive than they initially seem. Technology, when deployed and used properly, can help deliver better patient care, reduce inefficiencies, and lower provider burnouts. On the flip side, any operator who has been in the industry long enough can share examples of how poorly-deployed technologies led to high cost, added complexity – and, in some cases, even caused patient harm.
Even the best deployed technologies require a small army of people both within the company and organization being sold to for integration into other products and care teams workflows, and ongoing support. Some products require a full care model transformation within the care setting to get the promised results.
This time and cost must be considered by investors and founders when evaluating the viability of software-only products.
“Services” business models are getting more sophisticated and flexible
Another reason we remain compelled by services companies is that there are more opportunities than ever for companies to move from billing individual episodes of care, and instead to take on responsibility for the spectrum of a patient or whole populations’ needs. In other words, it’s not as simple as ‘doctor bills X for an encounter and insurance company agrees to pay Y, with company Z taking some margin off the top.’ That shift is also creating some compelling business opportunities for founders that are willing to go the distance.
We’re now seeing the rise of value-based arrangements. It’s important to understand that value-based care is an umbrella term for a large spectrum, that includes but is not limited to:
1. Bundles / Enhanced Rates - companies still get paid for access to a swath of services or to solve a discrete clinical problem, rather than itemize each individual thing they do. Oftentimes, this bundled rate is higher than the company would make as a traditional provider and reflects the perceived additional value they’re bringing to the table. Most employer-facing companies like Headspace fit into this bucket as they often charge a Per Member Per Month (for all members or engaged members only) for a swath of services. Bundled payments for costly subspecialty procedures are another emerging example. These models always require quality reporting and can also include quality bonuses.
2. Shared Savings - these models also include a shared upside if savings are generated.
3. Partial Capitation - companies can take on risk (upside and downside) for part of the cost of a patient. Some behavioral health companies take on risk for just the behavioral spend of their populations. Primary care companies can take on risk for just the primary care spend. These models can be challenging due to the “attribution problem” - everyone tries to claim themselves as the cause of the cost-savings or quality improvement.
4. Full Risk - companies like Oak Street, Cityblock and Agilon are among the best known for taking on full risk for the full cost of a patient. There is real evidence these models work. In its Accountable Care Organization population, Oak Street shared that its smaller patient panel primary care clinics reduced overall costs by 17 percent. Their care model, where they spend three times the average on primary care, has driven a nearly 50% reduction in hospital admissions and ER visits while maintaining a patient Net Promoter Score (NPS) of 90. ChenMed said it achieved similar results lowering hospital admissions and ER visits by around 30 percent.
What we look for from founding teams is an awareness that moving into these more value-based contracts won’t happen overnight – and it involves building the right kind of team. It’s a bad signal when a founder approaches this too flippantly – “Oh we’ll start Fee for Service, and then take on risk,” as if it’s easy. We’d want to see more sophisticated thinking about how to get there, and what types of hires will need to be brought in along the way.
Negative/low margins can be a temporary phenomenon (here’s why)
When we first see services businesses in the early stages, it is common to see negative margins or single digit margins. That can be off-putting to investors who are used to software margins and “hockey stick” growth, so here’s a few thoughts from us on evaluating these companies. We hope it’s helpful!
Most healthcare companies will start with negative gross margins. This in large part is due to a combination of low reimbursement rates (most likely because of unproven outcomes) with limited economies of scale on the cost side. As we’ve previously noted, many companies start off getting paid via fee for service, and eventually transition into different sorts of arrangements.
What we pay close attention to when evaluating services companies is the unit economics of care delivery. Let’s use an example of a hypothetical early-stage virtual behavioral health company.
On one hand we have revenue, meaning how much the company is getting paid for a tele-therapy visit. On the other we have cost, meaning how much money does it take to service that hour-long tele-therapy visit. In most cases, understanding the revenue side of the house is straightforward – most digital health tech-enabled services companies will get paid through a cash pay reimbursement model (direct-from-consumer) or a covered reimbursement model (payment from a health plan, self-insured employer, provider, or pharmaceutical company). However, there are caveats that are important for us all to understand.
First, these rates are not necessarily fixed. Cash pay often has some discounts associated and that must be considered in the model. Covered reimbursement can be renegotiated as outcomes improve (thus improving overall margin). Reimbursement varies drastically by plan, interpreted service, and geographic location. Reimbursement rates can often seem like a “black box” to the uninitiated and there is some art and science to negotiating for the most advantageous rates, but having experienced leaders at the helm is a big advantage. That’s something we look for.
So-called “costs to service” revenue can be a bit trickier. The most obvious service cost is the provider themselves. Specialist MDs have the highest rate, and it tapers from there. For some companies, understanding how various provider types are utilized to efficiently support a patient is also critical. In addition, it’s important to consider more than just hourly rates such as a provider’s utilization as this can drive a big impact. Examples include leveraging a team of sub-clinical providers to support care navigation and triage; bringing in Nurse Practitioners (NPs) for 1x1 visits; and engaging MDs for asynchronous prescribing. If a company’s providers are employed, companies are absorbing their full-time cost even if they aren’t being fully utilized. Considerations such as time to credential, matching supply and demand, provider churn, and supply retention are all key factors in improving the economics of the business.
There are also non-obvious costs that should be considered such as website hosting, messaging minutes, third-party vendor licenses (e.g., telemedicine), and more. Other cost centers worth mentioning are all the tech-enablement components, which includes the super expensive EMR. There might also be a physical component to the product, which could be in the form of hardware for a remote patient monitoring device or other monitoring, at-home lab kits or even a full brick-and-mortar clinic build out.
Margins aren’t fixed and can change over time. Let’s leverage an example with a different hypothetical virtual therapy organization. On day one, the therapy service may launch direct-to-consumer with a listing price of $100 per hour. In this model, the company is leveraging a 1:1 therapist model where the therapist costs $60 per hour and blended tech costs are $10 per hour. The contribution margin is straightforward and thin at $30 (30 percent). See our graphic below for how we got there:
Now let’s provide a scenario where the company commands a higher commercial reimbursement rate for delivering higher quality outcomes and contracting with commercial health plans. Furthermore, the company can gain economies of scale on technology costs ($5 per hour) and leverage a hybrid care model (text + video) where the therapist gains leverage. At this point, the blended time spent with each member is now 45 minutes or $50 per member. Now the company has materially expanded margins- from 30 percent to 50 percent.
Over time, expanded contribution margin lifts Lifetime Value (LTV). As companies build a stronger relationship with our members and obtain health plan coverage, retention increases (as fewer consumers across our population are paying out of pocket and thus less likely to churn). This relationship also creates an opportunity to broaden the product portfolio to solve adjacent problems for the same pool of consumers, with Livongo, Hims & Hers, and Ro being great examples of this play. Longevity and increasing breadth of usage for services companies when clinically appropriate is a key driver to achieve strong unit economic growth.
The big “bricks” question…
A question with enormous ramifications for services companies is if, how and when to invest in a bricks and mortar component of the product. This can dramatically change the piece of the value chain the company can own due to the range of services in healthcare that still require a face to face or physical interaction.
We see bricks and mortar being most important when there are clinical services that can’t be provided effectively without an in-person face to face interaction or hands on test/procedure, in specific places where there isn’t existing care infrastructure to leverage for partnership, and in companies with a very regional/market level focused strategy. For instance, even with the extension of the COVID Public Health Emergency (PHE), there are also still physical “site of care” requirements that need to be legally reimbursed by certain payors, especially CMS.
But with those benefits comes great complexity in managing company runway and profitability, as brick and mortar is known for being more challenging than tech-enabled services as it’s oftentimes slow to develop and high cost to build and maintain.
Here are a few ways to think about de-risking brick and mortar:
Founders should have a clear understanding of the timeline and cost to expand each brick and mortar unit within an existing geography, and into new geographies, that is reflected in the operating plan and runway management;
The team needs experience to manage the additional on site operations, logistics and CapEx of bricks and mortar;
There needs to be sophistication to determine when digital versus in person is the appropriate care modality;
There should be creative ways to design and deploy brick and mortar, such as using the envelope of existing care facilities for the build out (pharmacies, dentists, medical offices). Or by flipping the traditional model to bring the brick and mortar experience to the patient/community as companies like Tia Clinic or Homeward are doing with mobile clinics and at home visits;
There might also be creative ways to acquire brick and mortar practices when it's the bottleneck to growth, such as roll ups that fold the care team (and their patient panel) into the new larger organization, rather than the more typical roll up play that involves cashing physician owners out.
Remember: All of this is dependent on the stage of the company…
Thoughtful healthcare investors and founders should recognize the margin expectation at each stage of the business. The most impressive founders are those who truly understand the drivers of unit economics and can speak thoughtfully to the data, and the expected progression even very early. They also understand the “market unit” at which they are going to show a path to higher margins and profitability, which could be in a population, a clinic, or a region. Finally, they have a firm handle on the costs and timeline of growth (especially if the model involves brick and mortar) to manage their runway and eventually have sufficient profit to help invest in their own growth.
A pre-seed/seed company will most likely still have negative gross margins. A seed to series A company should have positive margins but may still be <30 percent. After the Series A, companies should show a clear path to 50 percent plus and quickly achieve that metric. The real ingenuity comes with understanding exactly how to scale from negative gross margins to 50 percent. Many companies have thoughtfully taken the path of increased reimbursement rates by demonstrating consistent, high-quality outcomes. Strong consumer retention and utilization can also help, particularly with employers and pharma.
Some of the best digital health companies have also gotten creative with how to maximize their supply, often employing non-specialized providers, and upskilling them to deliver specialized protocols through their own proprietary channels. Scale will also drive impact as demand more closely can match supply. Ultimately, founders that understand the key drivers of their business will have a better sense for how to improve and scale.
For more info, it’s worth checking out the great benchmarking that Bessemer put together on tech-enabled services companies. The top quartile of these businesses can have 30 percent + contribution margin with high growth even at scale. The rough range of gross margins is 25 percent in the bottom quartile to 60 percent in the top quartile. These gross margins unsurprisingly dramatically drive revenue multiples for these businesses.
Risk-based businesses like those we outlined above are particularly interesting. At scale, these businesses can enjoy a more attractive margin structure than traditional insurers. On the member acquisition side, patient interest in their specific providers and care model makes them far more differentiated than insurers who are finding acquisition increasingly competitive and expensive. Oak Street Health is already projecting scaled EBITDA of 30 percent for its centers which is higher than many traditional providers’ margins.
An additional note on Value-based Care
As the national health expenditure as a percent of GDP rose from 13.3 percent in 2000 to 19.7 percent in 2020, controlling and managing the growth of healthcare expenditure without sacrificing access and quality of care has been one of the priorities for the US government and key stakeholders in the US healthcare ecosystem. A major undercurrent from the past two decades is the movement toward “Value-based Care.”
While advancement in technology and the rise of digital health will be an accelerant (or game-changer compared to previous iterations of Value-Based Care), we must not forget that the majority of VBC enablement capabilities are very services-oriented.
Let’s look at some of the incumbent managed services organizations like Agilon Health, Aledade, Privia Health that are helping with the transition to value-based care. For those unfamiliar, MSOs essentially help with the administrative, or non-medical, work of managing a practice. Technology is central here, but a core of their offering is still the “services” to help providers succeed in the various value-based care models (MSSP, ACO Reach, Medicare Advantage, Commercial, etc). Privia Health recently shared a “five-step process” of helping providers move toward VBC – and there are services featured in both Category 2 and Category 3.
And a final word
Health care is by no means an easy space to build a business. But every year, we see more and more success stories in the space and great founders moving in. These founders are rethinking the experience of patient care for the 21st-century, which gets us immensely excited about digital health’s potential, downturn or not.
If you’re building a tech-enabled services company, we hope this is a helpful resource. Please reach out to any of us anytime with questions or thoughts on Twitter - we’d love to hear from you: @alyssajoyjaffee, @ianechiang @rebeccacoelius or @chrissyfarr.
Thanks for reading!