Resetting expectations for VC investing in health tech
We have been unicorn hunting for way too long
Here’s something I probably shouldn’t say out loud as an investor at a venture firm, let alone write about. But here goes.
Not everything and everyone should be backed by venture capital.
There are plenty of alternatives to this type of capital source and we don’t talk about them nearly enough. Because we are obsessed as an ecosystem with the venture model and the potential for startups to become unicorns. The vast, vast majority in health care will not be. And that’s okay. What worries me is when we try to force it - which I see far too much of and I’ll elaborate on this theme throughout this post.
Let’s start with some hard truths. We are in a period right now of disillusionment, preceded by a period of hype. For more on that, check out Bessemer Venture Partners’ recent excellent report on the valuations and exits in health-tech over the past decade or so. The authors noted that many of the financings of the 2020-2021 hype cycle were driven by the perceived increase in billion-dollar exits, both via IPOs and M&A. Most notable among them: Signify (sold for $8 billion to CVS); Oak Street Health (sold for $10.6 billion, also to CVS) and One Medical (acquired by Amazon for $3.9 billion).
If these companies could do it, the hope was that many others would soon follow. Hence the market conditions we saw in 2020 and 2021, which was also the time that I first made the shift into venture capital.
And then reality hit, just as the rest of the venture market (except AI) took a dive. It turns out that there may not be that many of these jumbo exits to be had in health-tech. Thousands of companies have been funded over the past 15 years in the sector, and yet just a dozen or two have achieved this type of billion dollar-plus status. Meanwhile, all the health-tech companies in the public markets were trading down, which eventually has a trickle down effect to impact private market valuations. All of that is playing out right now.
That is particularly concerning to the larger funds, particularly those that raised billions of dollars from their limited partners (LPs). For these funds, any solid outcome that generates liquidity can’t hurt. But the ones that really move the needle are the multi-billion exits, which represent a 10x or more return on their initial investment. These firms need a few of these with every fund they raise to continue to raise bigger and bigger funds (and therefore generate larger and larger fees). It’s the reason why investors like Peter Thiel have encouraged other VCs to bet on companies that will “return the whole fund.” This, by the way, is essentially the Power Law distribution thesis of venture.
Celebrating the modest outcome
But there’s a light at the end of the tunnel. While health-tech may lack a factory line of jumbo exits, there’s a relative abundance of far smaller exits, many of which are in the $100 to $500 million range – and even more common, in the $40 to $100 million range. These are often barely reported in the press, and we don’t hear about them because the financials are not always disclosed. I reported on a bunch of them in my prior journalism life and found the details fascinating. Selfishly, I think we should be screaming about it from the rooftops, presuming the company is allowed to do so by the acquirer. Because the founders doing that should be deeply proud of the accomplishment, even if it isn’t a unicorn.
So does that mean venture doesn’t work at all? Clearly not. If the venture capitalist is honest about what the company is – and isn’t.
One thing I’ve learned since making the transition into venture is there are smaller, sector-focused funds that are banking on these kinds of exits all day long. They’re not looking for the next Livongo - although I’m sure no one would sniff at an $18 billion outcome. What they’re excited about - and accounting for when they raise capital from their own LPs - is the next AbleTo, a $500 million-ish outcome. And those funds can still do well in a down market, in fact they’re able to get in on cap tables at far more reasonable expectations. They’re also less likely to stuff capital into companies that are starting to do well, which means entrepreneurs need to stay lean and make sensible, occasionally even tough decisions.
These funds were not the ones forking over term sheets with hefty valuations in the 2021 and 2022 period. For the most part, they sat that hype cycle out. What they’re underwriting to is an AbleTo-like outcome as the best case scenario, and an assumption that about half of their companies won’t succeed. What that often looks like is fewer bets and higher ownership thresholds, such as a minimum of 20% of the company at the Series A (during the ‘21 and ‘22 period, that would have been a huge challenge). Small-to-medium sized firms that are sector-focused in health-tech include 7wire, Santé, Frist Cressey and 406 Ventures. All these firms have raised less than $250 million per fund.
While these AbleTo-like exits may not set the world (or the media) on fire, we will continue to see a lot of them in health-tech for a few reasons. The obvious one is that incumbents are reluctant to fork out billions because it’s getting harder and harder to justify that to their own shareholders. There’s also questions of capital efficiency. Sometimes the unicorns have also raised a war chest (they’re worth $1 billion but have raised $500 million). Whereas these smaller companies have done far more with less and are therefore more attractive to a buyer.
A less obvious, but equally important, factor is health care is not a $4 trillion industry. Not really, anyway. Allow me to explain.
The TAM is not $4 trillion
Health care is actually a bunch of single-digit billion or hundred-million-dollar opportunities. It’s a scaled surgery practice or billing software that targets a certain specialty type. Or it’s a services business focusing on one patient population and standing out due to its superior outcomes.
Not everything, of course, is addressable with venture-backed disruptive companies, so it’s not truly $4 trillion (I’ve heard a few VCs argue, and I think there’s something to it, that the true TAM is more like $1 trillion because it’s estimated that about one-third of medical spend is unnecessary).
Many of the most successful health care companies stay in their lane and don’t ever become the kind of “mega platforms” that venture investors love. They're a niche business, but they’re killing it in their niche. Sometimes, of course, you see companies move out of their niches, like Livongo or Omada, which moved from the diabetes/pre-diabetes space into chronic conditions more broadly. But oftentimes you don’t, and there’s nothing wrong with that.
The entrepreneurs behind these companies, as well as the early employees, can do well with this sort of exit, provided the company doesn’t get overly stuffed with capital that comes with structure like liquidation preferences. Note that even in 2020/21, I saw some seasoned health care entrepreneurs turning down the term sheets with the biggest valuations because they know it comes with strings attached. If you say your business is worth X, it needs to be worth X on the timeline that is in line with a venture firm. Or a founding team will have to deal with increasing pressure and expectations from the board. We don’t talk about this nearly enough. But this is what you agree to when you take on a hefty valuation.
Outside of venture, there’s a whole fascinating world of health care companies that I’ve been spending more time with of late. I recently met with a founder of a company in the $5 to $10 million ARR range, which was operating totally under the radar. The founder had for the most part bootstrapped her business, focusing on physical therapy for postpartum women, and achieved profitability after a few years. The only capital she brought in came from friends and family. That allowed her to stay focused on her specific corner of the universe, versus feeling pressured to expand and grow at a pace that would have meant she had to sacrifice on things that mattered to her, like user experience and clinical excellence.
What keeps me up at night with venture as a category is that we’re trying to manufacture unicorns where unicorns shouldn’t exist. And that quest has put undue pressure on entrepreneurs to cut corners. I can’t tell you how sad it makes me to see health-tech companies in the press time and time again for behavior that casts the whole industry in a negative light. Take Cerebral or uBiome as an example – and there are countless others.
That’s not to say there are no unicorns in health-tech. Clearly there are - and seasoned angel investor Halle Tecco has a list of them here. I’m personally excited for the potential of some of the companies that haven’t gone out yet, but are waiting in the wings for the public markets to open up. But as venture investors, we need to think carefully about what kinds of companies within our sector can even grow at the pace that we expect to achieve the kinds of returns that keep LPs happy.
And no, this doesn’t mean stop investing in health care services to hard pivot to AI or biopharma. I do think that we should be taking on more technical and scientific risk. And I believe there is a role for tech-enabled services investing if and only if these businesses are valued correctly. These are not software-as-a-service companies. And we should stop treating them as such. Growth will be slower, margins will be lower, and that needs to be baked into the thesis. It reminds me of that moment in Mean Girls when Regina George tells Gretchen “stop trying to make fetch happen.” Services is not software. It just isn’t.
If not venture, then what?
We should think more deeply about alternative capital sources to bring into the fold. Private equity, for instance, makes sense for a lot of scaled clinic businesses, particularly those with a brick & mortar footprint. There’s grant funding from governments and nonprofits. There’s friends and family; family offices; foundations; crowdfunding; there’s loans from banks (although, a topic for another post, I continue to be concerned about the decline of regional banks); and there’s professional angel investors.
When venture was cheap - driven in part by super low interest rates - we viewed it as the panacea for all our funding problems. But that comes with a cost. When venture capitalists come in, they expect venture capital growth and venture capital returns. And for the most part looks like this:
Meanwhile, health care is very often a slow and considerate game. Many of the companies that I first wrote about back in 2012 for their launch are still at it. They’re still slogging away and growing but growing carefully. Sales cycles are long; incumbents are tricky to dislodge, and innovators are often perceived as too risky in their early years.
So if you want to build a health tech company, I commend you. It’s not going to be easy and you probably know that by now. But if you’re in it to win it, you’ll need to surround yourself with capital that gets that.
That’s all, I’ll get off my soapbox now.
Any thoughts? As always, I’m reachable on LinkedIn and Twitter or you can comment here on this post. You know where to reach me! And thank you to everyone in venture who read this post and provided feedback.