Second-Order Business Models in Healthcare

You can create a good business by driving your user acquisition cost to zero, charging your customers recurring fees, and managing your churn. Linear growth. You create a great business by finding a secondary revenue opportunity, one that scales as your business grows. Power-law growth. That opportunity comes after establishing a business that works on unit economics. There are several patterns: Amazon’s first business was on distribution margin, but it used the data and aggregation power it gathered to source its own products in key categories and move margin 10X; Facebook’s first business model was flat advertising, but in creating the social graph, Facebook drove their CPMs many times higher, while erecting powerful barriers to entry. In our firm, we say these businesses have Second Order Business Models. While great entrepreneurs have their Second-Order business model in mind from the beginning, it is a second act — built on an unfair advantage created with the initial business execution.

Linear Businesses in Healthcare?

This linear business model is profitable, but it’s not exciting. Because the cost of product development is so low in digital health, many companies can achieve profitability and can even reach $10 million in annual revenue. But breaking beyond that plateau is difficult. We’ve seen it over-and-over again. A good idea, solving a real need, often plateaus at $10 million of revenue. Why? Because barriers to entry are often lower in HCIT / digital health than they are in life sciences, so many more companies compete across a given solution set. Because it’s difficult to get sales momentum in healthcare, absent government mandate (e.g., Meaningful Use). Because many businesses have one direct value proposition and do not benefit extraordinarily from ecosystem dominance, aka network effects.

Take telemedicine. A company that sells telemedicine capabilities can generate a good linear business model by selling visits at $100/appointment * # patients. If it costs them <$100 to deliver the appointment, fully loaded, it’s a profitable model. What happens if the telemedicine company managed 100% of the telemedicine appointments in a region? That might give them incremental pricing power, but it’s still a linear revenue model. We look for the secondary business model. In telehealth, this might come from demand management, controlling the patient inventory, or it might come from something else, or it may not exist. Nobody has cracked the second order business model in telehealth.

As seed-stage investors, it’s tough for us to invest in linear models. Our cost of capital is high — due to expected failures and long investment time — so we need our winning companies to grow extraordinarily. In addition, the Second Order business model is usually the result of an unfair advantage created by successful execution of the first stage. Thus, inherent barriers to entry are created, further increasing value.

Second Order Business Models in Healthcare

Where do second-order opportunities come from? Two places: where silos are broken down and where industries evolve such that vertically integrated businesses begin to fragment out. Second-order businesses often exploit a new ‘edge’ that you create, for example Facebook and their social graph. As businesses fragment, like most do as they evolve (computer, gaming, oil, media), newly independent nodes exist through which new ‘edges’ can be created and new businesses built.

These conditions are present in healthcare today, creating many opportunities for Second Order businesses. We’ve been lucky to invest in several and are always looking for more. For example, SolveBio has cracked it in genomics infrastructure — a unit economics primary business model with a Second Order business of establishing the de-facto data standard and pioneering the ‘genomics graph.’ HealthCrowd has cracked it in messaging infrastructure — a unit economics primary business model with a Second-Order business of member activation. Current areas we’re excited about, and believe there are Second Order business models to be created, include: claims adjudication, referral demand management, discharge management, and solutions that power both demand and supply sides of provider appointment inventory.

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