How Venture Capital Works (And Doesn’t) in Health Care

I interviewed 40 VCs, health tech entrepreneurs, health care executives, and industry experts and spent hours researching the intersections between health care, public health, and venture capital. What emerged was a multi-part report that I’m calling Preventing Prevention: Barriers to Venture Capital Investments in Upstream and Community-based Care.

This is part two. (Part one was An Introduction and Framing and Jargon.)

Funding for this work came from the Robert Wood Johnson Foundation.

Intro and Overview: Some Types of Investors

Investors, like other groups of humans, come in all shapes and sizes and philosophies and levels of knowledge. Some are really good at their jobs. Others are not. In fact, and bucking what seems to be the myth around them, venture capital funds actually haven’t significantly outperformed the public markets since the late 1990s.

But enough venture capitalists do quite well, and it’s the allure of this possibility that keeps them thriving both as a part of our economy but perhaps even more so in the imagination of America.

Angels vs VCs vs Private Equity Investors

We’ll be looking, through this blog series, at how venture capitalists (VCs) operate, their perspectives on a shifting health care system, and their inclinations to invest in tech-based products that aim to hook into the health care system in order to help prevent diseases and promote healthy behaviors.

To understand where VCs fit in the investment spectrum, need to differentiate them from Angel Investors, Private Equity, and others:

Angels provide seed funding

In the earliest days of an idea, an investor can be referred to as an angel. These angels make bigger bets. There’s not a lot of evidence at this point that the business idea is a good one nor that the entrepreneurs are the right ones to take the idea forward. In fact, the risk reward payoff, or lack thereof, points to the real reason why many angels exist: Often angels are semi-retired investors who enjoy mentoring young entrepreneurs. Many aren’t there hoping for big financial returns. They may have particular goals they’re pursuing, like focusing on certain types of CEOs, and may even have a philanthropic bend to them.

From an ecosystem perspective and through the lens of the young startup, an angel’s goal is to support a company’s validation of their business idea by build just-good-enough evidence to go to the next level.

The Angel is often a key go-between to help an entrepreneur get in front of the next phase of investors.

Venture Capitalists Invest in Series

Venture Capitalists (VCs) tend to enter the picture after some early business validations have occurred. VCs fund through a spectrum of risk, from series A (early stage) to B and then to C and maybe further. The funding and growth strategy, that is: the number of funding rounds that a company goes through, depends on that particular company and their growth strategy.

VC’s role in the ecosystem is to take an early-stage concept that has early validations and take that to scale (quickly). There will be adjustments along the way, but VCs mostly see themselves as funding a high-growth phase of a company that is critical to taking market share, establishing dominance, and solidifying organizations structures around the business model that drives sustainability.

The amount of money invested by a VC and the return expectations vary on the stage of investment, their own risk-reward analysis, and in their overall investing philosophy. Still there are some general trends to note:

• Series A investments are between 5 and 15 million with expectations of a 10–20x return
• Series B investments are between 15 and 30 million with expectations of a 5 to 12x return
• Series C investments are between 20 and 40 million with expectations of a 3 to 6x return.

VCs typically have a 5 to 7 year outlook, but approaches to risk management vary.

It’s worth noting that most VCs aren’t investing their own money. They’re managing a Fund created from the dollars of Limited Partners (LPs). It’s these LPs who are taking the real risks and thus who reap most of the rewards (and suffer the losses). Many VCs get paid simply from the fees levied on the companies they invest rather in than in the returns that company garners.

Strategic Investors are Investors with an Agenda

These VCs get a special mention here as a sub-type of investor. They aim to shape in a very specific way a company they invest in. For example, a strategic investor from a large organization may want the data being collected by a company, or they may be shaping a startup so that they can later be acquired by the company this investor represents. Other strategic investors may have more altruistic motives. For example, Kapor Capital is an investment firm that focuses on increasing diversity in companies. Or the California Health Care Foundation’s Innovation Fund uses their investments to nudge for-profit companies to work with marginalized populations often within the typically-neglected Medicaid market.

Strategic investors are very explicit on their intentions. Indeed these are all put in writing in what are called riders to the investment. It’s up to a company CEO to decide whether or not to take on these strategic investors and their riders. If the visions of the CEO and the strategic investor line up, then it makes sense. Otherwise, the deal falls through.

Private Equity Extracts Value From Markets

In later stages of investing, private equity (PE) and investment bankers (IB) play.

Whereas VCs still hold fairly high risk and thus make decisions based not just on numbers but also on their gut instincts (more on this below), PE and IB investments decisions are largely made by math; that is, by hard data-driven analysis of a given market and companies operating within it.

PE and IBs are looking to extract value out of a market in some way. Whereas VCs may just put in funds to have a seat at the table, PE firms typically acquire companies whole, through purchasing a majority of the board seats, in order to make some significant changes. They may reorganize a company, take it public, or work it through a merger or acquisition.

Similar to VC funds, PE funds come almost exclusively from LPs.

Evaluating the Success of a Venture Capital Fund

Once a company matures sufficiently, a VC will be looking to get their money and then some. They can do this through a few possible actions: Being paid out from corporate revenues, taking the company public, selling the company to a larger one, or allowing a Private Equity Firm to take over.

Each of these options are considered viable exits. Most companies and VCs have — or at least should have — a sense beginning in their early stages as to which option they’re running towards. There’s a bit of an art, of course, to knowing which route is best and when and how to capitalize.

But importantly, success for a VC is not simply making money. Anyone can make money. Rather, success is measured in dollars relative to other investment options at a given time.

For example, one can easily invest in the stock market and ride the general index. For example, the S&P 500, which is generally the fund against which investments are benchmarked, has a historical average annual rate of return of 10% (7% when adjusted for inflation). Investors, of course, want to at least do better than this, but they also want to outperform other investments made, including by other VC firms, in a given year.

To evaluate their relative success, many firms use benchmarks published quarterly by the firm Cambridge Analysis (not to be confused by the more infamous Cambridge Analytica). Their reports track investments by year — or more technically: by “vintage year”, the year that a fund was formed — and break down the spectrum of VC fund performance by Quartiles.

So VCs not only want to beat out the stock market, they want to beat out investments made by other VCs in a given year. This signals a good management of funds!

Which gets us to another point: Success in the world of a VC goes beyond any one investment. While an individual investment made in a company is certainly tracked, this is just a single company within a larger portfolio. It’s the success of that overall portfolio that matters.

A fund’s portfolio is likely composed of more risky and less risky investments. Some companies are “hopefully 2x”, some may be “likely 4x”, and some that — you eventually see — you just hope to get your money back on (but likely won’t). The function of (perceived) risk and (expected) reward is stratified across the fund. The product — the makeup of the portfolio — reveals an investment firm’s risk tolerance and philosophy.

What Drives Investment Decisions

Typically investors specialize in a given market. They (or at least the good ones) know how a market is trending, shaped by policies, technologies, and consumer behaviors. They (again: the good ones) have well a defined thesis, a statement of belief that lays out their understanding of what’s just-over-the-horizon.

Health care investors tend break the industry down into the following market domains:

• MedTech (e.g. devices)
• Biopharma (e.g. pills)
• Health IT (e.g. EMRs)
• Services (e.g. at-home nursing visits)

While some investors are “general”, most specialize on one of these areas, or even a sub market within one of these. Within their market, a VC talks to hundreds — yes, hundreds — of companies a year. And of those hundreds, they typically will fund only between 1 and 3.

Why don’t they invest in more companies? Why not take more bets? Are there really only a few companies worth investing in in a given year?

The factors going into the decision to investment in a given company vary. Different VCs have different risk profiles, but I’ll highlight a few variables of particular interest to our discussion.

VCs Invest in the CEO Entrepreneur

Contrary to popular belief, investors are not funding exciting ideas. They fund markets. And they see, or try to see, where a market is headed.

The question then becomes: Who will take the market there? Many will try! But only a few will prevail. And it’s the job of a VC to find that entrepreneurial CEO with all that it takes to succeed and build the right company at the right time.

The VC investment is made in this person. Not in the idea, per se, but in this person, in his or her ability to effectively to build a well organized and effective company, to cultivate and evolve a smart business model, and to navigate difficult managerial and business situations to figure out how to get through the thick and thin of where the market is taking them.

The investor is there to help. They sit on the board of the company and offers their guidance and experience along the way. Which points to a final human dynamic at place: The relationship between the entrepreneur and the investor is critical. The chemistry between them, perhaps driven by similar personalities or a shared vision, is a variable that a VC considers when evaluating a company. “We’re family,” is a common trope. It’s a partnership that goes beyond business hours, calls at 2:00am to help the CEO think through an issue are not uncommon.

The Unit Economics Demonstrate Sustainable Business Models

Assuming the entrepreneurs at the helm sufficiently demonstrate their personal abilities, a next set of questions an investor may ask pertains to the business model created.

Over-simplified, the business model presents how a company is going to get money and how that money will be spent. It presents the argument that an entrepreneur hasn’t just a decent solution to a given problem in a given market but that they also have found a sustainable way of delivering it. That the money coming in will be more than the money going out.

When a VC evaluates a company, the math gets broken down to the individual unit: How much can you get a given (typical) customer to spend over their time as a customer? And: How much does it cost to find and then sell to that (typical) customer?

Put these two questions together and you get this key metric:

Lifetime value of a Customer (LTV) / Customer Acquisition Costs (CAC)

If you’re looking for a sustainable business model, this number needs to be bigger than 1. If you’re looking for VC funding, this number needs to be closer to 3.

Some VCs, particularly in later company stages where there’s more data to analyze, are more dogmatic about this metric than others, but most at least use this as a guiding post.

Various decisions shape a company’s LTV and CACs:

• LTV: Are people paying once for a service? Or is it a subscription model? Do people pay by usage? How long will they be around? Can we get them to buy more than they initially bargained for? Can we get them to buy something 3 years from now? Maximizing LTV is a function of the pricing models and the length of time that company has an engaged customer.
• CAC: How do we find potential customers? And then, how do we hook them to become actual and hopefully repeating customers?

Note: The marketing and sales arms of a company end up being really critical divisions of a company. (This makes sense when you think about the role of VCs to fund the commercialization of an idea.) You can have an incredible product that is worth nothing if no one knows about it, and nothing still if people know of it but don’t see how it can help them.

Further, this LTV/CAC metric isn’t stagnant. As one entrepreneur told me: “The savviest investors ask you how you expect your LTV / CAC to evolve over time vs. what it is now.”

Figuring out how to maximize LTV and minimize CACs while growing a business are what make profitable companies profitable. And in the early days, a VC’s ability to understand how the metric can evolve over time for a company in a given market is critical to determining whether or not the investment gets made.

Total Addressable Market Shows Growth (Return) Opportunity

But simply having a quality entrepreneur with a profitable business model is not enough to warrant VC funding, for an investor wants to be able to estimate the returns they may have on their investment. To get to this, you have to know another key element of the market: The total addressable market (TAM).

The TAM is the product of all potential customers times the price of the product or service. If you take the unit profits and multiply it by the TAM, you have the total potential profit to be made within a market.

As with all metrics, there’s an important discussion over the best way to calculate the potential market a company thinks it can grab. (For example, does it really make sense to assume that you’re going to sell to everyone within a market? If no, then really we should be talking about Serviceable Available Market [SAM] and Serviceable Obtainable Market [SOM].)

But we’ll simplify things for our purposes here and just say that VCs are looking for a really big TAM. Indeed, most are looking for TAMs of at least $1 Billion.

How Do Investors Think About Prevention?

One way to frame a premise underlying this series of blog posts is: How do investors think about, and thus invest in, prevention?

The short of it is: Well, they don’t.

The industry of venture capital operates on a set of values that state that markets hold the truth. (Note this isn’t talking about the individuals particular values, but rather those that underlie the industry and their professional decisions.)

In contrast, public health professionals tend to operate through the lens of what they see is “right”. They operate through values of fairness, equity, and social justice. There’s a perceived “better way of doing things” that drives their day-to-day work. The work within public health is to make real a vision of the world shaped by these values.

Or as one VC told me: “Public health professionals are doing God’s work.”

The statement here was not a criticism of public health but rather points to a distinction in his mind: Public health experts tend to work outside of market forces, against the flow of market forces, or in policy trying to change the direction of market forces. Venture Capitalists, on the other hand, work within those market forces.

An investors, therefore, doesn’t think about prevention any more than a market “thinks” about prevention.

As another VC described it: “We exist so as to quickly scale up and test new ideas. If [public health experts] want us to work on a particular problem, just change the policy to tell us where to go and we’ll go there.”

One can map investments made into categories we create and determine which ones are more “prevention” or “community”-oriented. But this does not say anything about VC efforts to spur prevention-oriented work; rather it is more a reflection on how markets are structured.

Economics, duh

So in a broad stroke, and a fairly obvious one at that, a major barrier to investing in more upstream drivers of health gets down to simple economics. The markets aren’t properly structured. The business models of working upstream have LTVs that are too low and CACs that are too high. The math just doesn’t add up.

But leaving it here is too simple. We need to move to the harder part: Unpacking how the economics play out within different slices of our health care system to identify more specific barriers.

To do that, we need to look at how money flows from payers to providers.

Next Up: How the U.S. Health Care System Works (And Doesn’t)