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The Squeeze Continues…Early Stage Health Tech Deal Volume Falls to New Lows

by Michael Thomas

Five consecutive quarters—and counting—of declining deal counts in pre-seed and seed-level investments for health technology startups in the U.S.

Groundhog Day?

This month, Forbes reported that venture capital investments in healthcare startups hit record highs, despite the infamous dissolution of Theranos. While this implies it is still a buyer’s market, hundreds of quality early stage-health technology companies ready for funding are not securing investments. At Inova Personalized Health Accelerator (IPHA), we researched this trend in our Health Tech Early Stage Funding Report, which we published this month. As reported in VentureBeat earlier this year, Rick Gordon, director of IPHA, detailed a troubling trend at the pre-seed and seed stage investment level for health technology startups – early stage health technology investments are declining.

With the latest data from Pitchbook, it seems that this squeeze has not abated. In the recent report from our team at IPHA, the Q2-2018 data from Pitchbook reveals that the number of health tech deals valued at $10 million or less continues to decline to a level not seen since 2013. Our analysis indicates that deal volume has fallen nearly 45 percent since Q1-2016.

According to Forbes, “over $20 billion has gone into 1,186 deals during the first eight months of 2018, up 59 percent from a year ago and up nearly 180 percent from a decade ago.” However, the recipients of this good cheer are everyone but pre-seed and seed-level health technology startups.

The New Normal?

With such a precipitous fall over five consecutive quarters, should early stage health technology entrepreneurs panic? Although the Theranos fraud, while making sweet fodder for salacious headlines, has not affected investor interest in later-stage investing, something is rotten in this state of early health technology investing. As we found in the IPHA report, venture capital funds as well as angel investors aren’t investing in early stage health technology. Neither are health systems: fewer than 50 of the more than 1400 early-stage deals were completed by health systems since January 2017.

We’re from the government, and we are here to help you…

Why is early stage health technology investing in a bear market while late-stage VC investing, and the public market indices continually hit new, all-time highs? Are investors afraid of the FDA? Under Commissioner Scott Gottlieb, M.D., the FDA has been dramatically increasing the number novel devices approved. In 2017, novel drug approvals by the FDA hit a 21-year high. The FDA’s commitment to applying the “least burdensome standard” for generating information critical for medical device approval was strengthened and advanced by provisions in the 21st Century Cures Act in 2016. This policy approach has catalyzed the FDA’s efforts to help innovators generate high-quality evidence that can support marketing approval as efficiently as possible. In other words, the FDA is helping to mitigate early-stage investor risks for innovative health technology products.

The Not-So-Final Word

If the global healthcare market is expected to hit nearly $9 trillion in 2020, then what are early stage health technology entrepreneurs and investors to do?

As seen in the public markets from 2009 through 2018 with the Dow up over 406 percent including dividends, all bear markets will end, and new bull markets launch with little warning. The pace of health tech innovation continues to accelerate with the NIH, HHS and NSF funding nearly 100 new innovative startups in the past 18 months.

When traditional technology ventures experience a raging bull market, as they are now, many investors tend to favor those investments over ones with more regulatory risk. However, the world of health technology is rapidly evolving — the global population is getting older and rampant obesity is not purely an American health crisis. Meanwhile, new discoveries in genomic testing, CRISPR therapies and AI/machine learning are advancing life-altering solutions for suffering patients. With the impending, albeit slow, launch of 5G wireless technology, which could allow for an increasing amount of ultra-reliable communications within the healthcare space, the pace of health technology innovation will undoubtedly accelerate in the coming years.

IPHA believes that now is the time to be a contrarian investor. Valuations for pre-seed and seed health technology ventures are likely to reflect the low volume of investing activity. There’s no way to know if this bear market on early-stage health technology investing has hit its nadir. Over the past two quarters, we have observed early stage deal sizes jump as has total capital invested in the sector. One could argue this is due to more money chasing fewer deals and resulting in a price increase. On the other hand, it could be the current funding environment where the market necessitates taking larger rounds than in the past, indicating capital is consumed by fewer deals.

But, on a risk-adjusted basis, investors should expect a regression to the mean for these opportunities. The average deal size for early stage investing in 2017 was an estimated $1.93 million, while in Q2-2018 it was $2.55 million for 54 fewer deals.

We feel that the pendulum has swung too far to the negative with early stage health tech firms. When one speaks of “regression toward the mean,” or average, they are speaking of the phenomenon where an extreme measurement tends to move closer to the average upon successive measurements.

Groundhog Day Redux

Health tech companies are having more trouble securing early stage financing. Therefore, these ventures are more mature when they go for initial financing and are commanding a higher valuation. As a result, investors are allocating more funding into these rounds. For investors, bigger checks can be put to work at more mature companies while they wait on pre-seed and seed deals to achieve more risk-reducing milestones.

While funding is more difficult to secure in terms of number of deals, the overall amount of investment dollars is increasing. The bottom line: innovation is definitely not standing still. Capital is flowing into later stage companies. Assuming the laws of supply and demand still hold true to today’s investing environment, this makes pre-seed and seed investing opportunities very attractive.