The new dance between VCs and digital health companies

Exploring what makes healthcare different to other industries and how that affects your investing style. By Jack Needham

Recently, Nikhil Krishnan released a piece on his blog Out of Pocket, called “Digital health needs more creative financing options” and he sought to answer whether venture financing had been the right instrument for funding digital health companies. It was interesting. But I think there is a flip side to that coin, what do investors need to do to get good returns from digital health?

In today's very different macro environment, LPs (Limited Partners) are more protective of their limited capital. Are healthcare focussed venture funds the best place for it? In this blog, I will explore a couple of things:

  1. The dynamics of VC - how a fund works, in the most basic form.
  2. The differences in healthcare - how healthcare is different to traditional Saas and why it matters to investors.

The dynamics of VC

Let’s start with the basics: how do venture funds work? Take a $100m fund called Mad Rich Capital focussed on seed to series A investing.

Funds like this typically have an 8-10 year lifecycle. Capital is deployed over 2-3 years and the next 5-7 years are portfolio management and helping founders deliver exits. The caveat here is that it can be deployed faster or slower depending on the macro environment and fund strategy. The expected rate of return for a good venture fund is somewhere in the realm of 20-30% a year.

Jason Lemkin (founder and investor) answering a question on Quora.

Most Saas companies have a 10-year lifecycle until a capital event (an opportunity for investors to get their money back). Uber was founded in 2009 and IPOd in 2019, Snowflake started in 2012 and IPOd in 2020 and there are 100s more examples. Here is some data on the median time taken to IPO after initial funding.  So at the end of the 10 years, Mad Rich Capital has made ~$400m+  on its portfolio (4x like Jason Lemkin mentioned in the photo). Now there are a bunch of general partners on Twitter announcing how “proud” they are to have been part of the journey.

It is important to note that venture capital returns obey a phenomenon referred to as “The Power Law”. This means that returns are not divided equally across the portfolio of investments but are heavily skewed towards a couple of companies or in some funds just one. This is important because as a venture fund, you need to only be right once to succeed. It can be visually represented in the following graph:

On the surface, you would expect Healthcare to be an awesome place for VCs to invest. Healthcare represents 18% of all spend in the US economy and is growing at 5% a year; not only that but the software in healthcare has gigantic moats and is very sticky. We joke in the industry that Epic is quite possibly the worst software in the world (in terms of design and usability) but the company does $3b a year of revenue and no one has managed to uproot them over the last 30 years.

Something on Epic.

So why should VCs be thinking about how they are investing in healthcare?

The differences in healthcare

There are some fundamental differences in healthcare that you need to be aware of to get outsized returns as an investor. Here are my thoughts:

1. Valuing healthcare is hard

In a 0% interest rate environment, investors got lazy with the way they valued business. They  started applying blanket rules rather than operating in the nuance. 10 years ago, legendary investor Bill Gurly wrote an essay called ‘All Revenue is Not Created Equal: The Keys to the 10X Revenue Club’ where he eloquently outlines why you should not consider all revenue the same and thus not value businesses on a revenue-based metric. Gurley argues that the most effective way to value a business is through discounted cash flows but acknowledges this is almost impossible to do at the early stages and so investors default to more simple metrics like revenue multiples. The problem with valuing a business on revenue, he highlights,  is that “not all revenue is created equal”. The thesis of the rest of the essay is that there are core characteristics to a company and the revenue they earn that makes it “more valuable” than that of another company's revenue.

To apply Bill’s thinking to healthcare, Google's revenue is fundamentally different to that of a company delivering virtual care. Google has profound network effects, a sustainable competitive advantage, and huge margins among other things. A virtual care company (take your pick) might have none of these things and yet for the last 10 years of venture rounds in digital health, they have been financed on the same metrics as Saas: a large multiple of revenue.

Oscar Health has dropped 82% since its IPO and at one point had a smaller market cap than its total revenue (not depicted here).

The truth is that valuing a business is hard and takes discipline. It can be easy in the rush of a competitive deal, to lose sight of first principles and not maintain your investment standards.

As Miles Grimshaw from Benchmark puts it, investors need to be biologists, not physicists. Instead of applying blanket laws and rules, investors must understand the genetics of each company - what are the core characteristics of a company and its market that will drive outsized returns as opposed to applying blanket rules they have seen work in the past. Digital health companies have very different genetics to the Googles of the world and so the horizon of outcomes will be very different.

According to Pitchbook, as of June 2022, more than 140 VC-backed businesses that went public in 2020 have lower public market valuations than the total amount of capital raised. And these aren’t bad businesses or bad investors, but when you have unlimited free money circulating the system, you get sloppy. The lines blur and you get lazy about differentiating companies. So what was the outcome? Well as the graphs above show, many investors lost money in the most recent round of digital health graduates and this will happen again unless we begin to confront the harsh reality of healthcare: they are not tech companies.

2. Building in healthcare is hard

To anyone operating in healthcare, you will know that complexity is an axiom of our industry. It takes time to build and scale any offering in healthcare. If you are building a company providing care, the silicon valley cliche of moving fast and breaking things definitely doesn't hold - it will kill people. Digital health organisations are healthcare companies before they are tech companies, and so should be valued as such. These types of businesses will suffer from the problems outlined above. And if you are building enterprise software in healthcare, the odds are against you. Will Manidis perfectly outlines why below:

As Will goes on to highlight in this Twitter thread, there is still a huge opportunity for big monopolistic outcomes but the path there is deeply unconventional. The largest companies built in the enterprise healthcare software space over the next 10 years won’t look and feel the same way conventional saas companies do; instead, they will look like service companies with hugely unscalable processes, fixing unconventional problems.

To go back to Epic as an example, the company was started by Judy Faulker in 1979. Its growth has not been meteoric but methodical and intentionally so. Integrating a system that manages health records, revenue cycles, patient experience and more takes time. In a Forbes article, she said that Epic has never lost an inpatient client, with the average tenure of a customer being over 10 years. THAT IS INSANE. The article goes on to say that during the pandemic, AdventHealth announced they would be launching Epic across their 37 hospitals. The full installation will take over three years and cost around $650 million.  What other Saas services do you know that take 3 years to implement?

When Will says the biggest business in enterprise healthcare software will start as services companies, this is what he means. Epic has spent 30 years building big bespoke integrations for its clients and over that time, it has figured out how to scale its offering. This willingness to do the ugly service-based work that takes 3 years to complete has made the Thanos of healthcare. They are almost inevitable.

So what does this mean for venture capital? Well, the standard fund cycle of 10 years might not work. Investors might need to throw everything they know about conventional saas investing out the window as they begin to make bets on a new era of healthcare enterprise software companies. The idea that you can go from $0-100m in revenue in 6 months through infinitely scalable software is not a thesis that will work on healthcare saas. The higher margin saas companies will take 15+ years battling long, unrepeatable sales cycles before they reach a high enough ****exit velocity. And they will do this in a way that feels very strange to those familiar with standard software investing.

Wrapping up

Many very clever people have been saying that a lot of startups will die over the next 12 months as the cash runs out and J Powell turns off the money tap. The same will be equally true of healthcare investors, just over a longer time frame. The most recent vintage of venture funds has birthed bad fund managers who will, in all likelihood, die a slow and miserable financial death similar to the founders they funded. It will only be when the fund cycle is completed and LPs come to collect their returns, of which there will be little, that the wheat is separated from the chaff.

But there are some really exciting opportunities. The nature of the landscape has changed, and the managers that grasp this will execute a new era of capital deployment on businesses that will be the largest healthcare has ever seen. This will require disciplined and financially literate investing as well as operational expertise within healthcare. If you are able to pick and effectively fund this new era of enterprise healthcare software and care platforms, I think there are some incredible returns still to be made.

Some useful links that informed this blog:

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