Medical Device Link.

Originally Published September 1999

FINANCE

Venture Incubators: Turning Product Ideas into Profits

In a world where fewer than 5% of new companies win VC funding, incubators can mean the difference between new technologies reaching the market or entering oblivion.

Scott Wolf

Just as hospitals use incubators to nurture newborns and coax them toward vitality, some medical device companies are now using "incubators" of their own to grow new product ideas into thriving ventures. These "venture incubator" firms—which may or may not be directly affiliated with a medical device manufacturer—work with venture capital investors and corporate partners to offer entrepreneurs the financial, technical, and management support they need to develop their concepts into profitable businesses.

Like venture capital (VC) firms, incubators invest cash in a start-up in return for an ownership stake in the venture. But, in contrast to their VC counterparts, incubators are willing to work with inventors who may be unfamiliar with company development and who have not yet refined their concepts. Innovation is key: inventors don't have to have product prototypes, patents, a management team, or even a business plan—just a product that promises to score big in the marketplace or meet a niche need. In a financial world where fewer than 5% of new companies win funding through VC sources, incubators can make all the difference between a product that makes it to market with a strong sales and distribution plan in place and a product that dies on the drawing board.

In addition to offering another source of funding for entrepreneurs, incubators extend another advantage—their staffs include professionals who have worked in the medical device industry and thus understand its ever-evolving technology, stringent medical standards and government regulations, and patients' insatiable appetite for healthcare improvements.

Make no mistake, medical device firms that utilize incubator services win, too. For established medical device companies that struggle with the need to fund promising, early-stage technologies and the desire to show increasing earnings, affiliating with a venture incubator allows products to be spun off or developed outside normal channels. Growing these "side" businesses in a newer spin-off company can provide the best of two worlds: an opportunity for investment appreciation as well as an inexpensive way to fund risky but potentially profitable technologies outside of the company's R&D budget. The venture incubator also offers an avenue for the development of noncore products.

Perhaps of even greater value, device companies that become incubator partners gain a window on emerging technologies. By supporting the efforts of inventors (often surgeons and other physicians who create new treatments for the patient conditions they see every day) in the initial "seed" round, they get the chance to follow technologies with the potential for future marketing relationships or acquisition.

How Venture Incubators Work

A venture incubator's initial goal is to develop a medical device idea quickly and efficiently to the point where the emerging company can attract a world-class management team to continue to grow the business. To achieve that objective, venture incubators provide the following resources to medical device start-ups.

Operating Capital. The amount of money venture incubators invest in an idea varies from about $200,000 to $5 million for the first round of funding, depending on the product concept's stage of development and the start-up's R&D needs. As the product meets developmental milestones such as completed preclinical testing or 510(k) approval, additional funds are committed. Unlike VC firms, venture incubators aren't restricted by investment minimums, and they generally aren't as pressured to produce a return on their investment in a certain amount of time.

One company that has benefited from the financial input of a venture incubator is CardioGenesis (Sunnyvale, CA), one of the innovators in transmyocardial revascularization (TMR). Guidant Corp. (Indianapolis) spun off the TMR technology to an incubator that invested $1.25 million in a seed round in 1993. The partners of the incubator and other investors eventually invested another $20 million in the company before it completed an IPO in 1996.

Experienced Management. Incubators also can provide whatever management assistance a start-up needs, from CEO on down. Once a company reaches the point that it needs a full-time CEO, the incubator retains an executive recruiter to find one. As might be expected, business leaders with the skills and experience necessary to grow new companies are in great demand; therefore, venture incubators must be able to present a compelling product and opportunity to attract them.

Research and Development Expertise. A "compelling opportunity" usually consists of a fledgling company successfully completing a proof-of-concept experiment, building a respected scientific advisory board, and working with clinical and regulatory consultants to create a product development plan. Most venture incubators have access to contract specialists who can assist with these tasks. The venture incubator also maintains relationships with opinion leaders in the various clinical specialties that use medical devices. These leaders can advise on specific product design features needed for clinical implementation, important clinical trial endpoints, and so on.

Venture incubator Itasca Ventures (Minneapolis), for example, is able to move an idea from concept to reality by using contract development and engineering firms. One such company, Medventure Technology Corp. (Louisville, KY), provides all R&D services that a start-up medical device firm may need, including engineering, design, development, and manufacturing. The company also has clinical and regulatory consultants on staff to guide the start-up's interaction with FDA.

David Phelps, Medventure's president, requires that the start-ups he supports be backed by venture incubators. "We have found that the early-stage companies that are working with venture incubators have a better understanding of the product development process," he says. "Consequently, they have a better chance of success."

Avoiding Common Mistakes

As in any market segment, many more new medical device companies fail than succeed. To push the odds in their favor, venture incubators help start-ups avoid the most common mistakes entrepreneurs make when building their companies. Such mistakes include:

Lack of Focus. Many early-stage companies seem to change their focus at will—trying to develop more than one product or application simultaneously. "Fifty percent of the early-stage companies we evaluate are diluting their product development efforts through a lack of focus," says Jay Schmelter, principal of Crescendo Ventures (Minneapolis). Venture incubators realize that start-up companies have the resources to develop one product, and the development of that product is what will add value to the company. Even when the company is developing a platform technology that can treat many diseases, the smart (and ultimately successful) company will pick the most promising product and devote all of its resources to developing it. Venture incubators make sure start-ups stay focused.

Overgrown Overhead. The growth of a new company's organization must match the development of its product. Because entrepreneurs are by nature ambitious, they want to grow their organizations quickly. Many organizations have a large, bright management team; beautiful facilities; and a world-class board of directors—but no product that has undergone proof-of-principle testing, and thus, no chance of long-term success.

Venture incubators try to grow the company with the product. When the technology is in its early stages, the company is run as a "virtual" company (that is, many tasks are contracted out rather than performed by full-time employees) until proof-of-concept animal testing has been completed. The incubator's president acts as interim CEO of the start-up, working with consultants and contract research and engineering firms to quickly prove early-stage product concepts.

Undercapitalization. No doubt you've heard it before, and it's true: the most common reason that new businesses fail is lack of sufficient operating capital. An early-stage company must raise enough money to prove its product concept and build enough value into the company to justify a second round of financing. Venture incubators try to fund start-ups with 12 to 18 months of capital so that the CEO can concentrate on product development and team building, not on fund-raising. As the company successfully reaches its developmental milestones, the venture incubator invests additional funds.

Unrealistically High Valuation. Because of the competitive VC environment, valuations for some highly sought after early-stage companies have risen. This situation has led some inventors to believe that VCs are willing to pony up cash at very high company valuations.

Thinking in terms of short-term gains can kill a great product idea. Unrealistic inflation of a new company's valuation may eventually cause the company to collapse. Even if the company can raise money at the desired valuation, one misstep might force it to ask for funds at a lower valuation in a later round of financing—the dreaded "down round." Lowering a company's valuation creates negative perceptions and dilutes management's position. Obviously, it's much better to increase your company's valuation slowly over time.

How to Find a Reputable Firm

Suppose you have a device idea and would like a venture incubator to help you grow it into a business opportunity. Where do you find an appropriate firm?

One of the best ways to identify reputable incubators is to contact other medical device entrepreneurs for referrals. Unless you'll be competing directly with them, such people will probably be happy to provide contacts, recount their experiences, and offer advice.

Another source of incubator referrals is medical business magazines or entrepreneur or VC publications. You may also want to contact established medical device or VC firms for referrals to suitable incubators.

Once you've identified a few firms, evaluate them carefully to ensure that they are qualified for your project and that you'd be comfortable working with them. Growing a new company is a long and sometimes stressful process, so it's important that you feel you can build a long-term partnership with the incubator. Meet the principals of the firm and especially the person who would be assigned to your project. Ask what the company would do for you, what resources it has available, and, of course, what it requires in return for its services.

Finally, look closely at the firm's track record. Is it experienced working with your type of product or technology? Does the firm display proven skills in organizing and financing new ventures? Have a sizable percentage of its projects been successful and grown into viable companies? Don't just take the firm's word for it—ask for at least four references and check them out.

Medical device developers face a host of obstacles—regulatory roadblocks, intense business competition, and potential technical problems or early obsolescence—that can keep a newborn product idea from ever getting to the market. Working with an experienced venture incubator helps many entrepreneurs overcome these risks and achieve their patient-care and business goals.

Scott Wolf, MD, is president of Itasca Ventures (Minneapolis), a venture incubator firm that specializes in developing early-stage medical device companies.

Illustration by Ken Corral

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