Medical device companies have long attracted the attention of private equity and venture capital investors; however, recent changes in the health care regulatory landscape have raised questions about the vitality of such transactions in the context of medical device companies.

For example, the 2.3 percent medical device tax introduced under the Patient Protection and Affordable Care Act, which applies to sales of certain medical devices after Dec. 31, 2012, has been characterized by the Medical Device Manufacturer’s Association as onerous and possibly crippling for smaller medical device companies. The MDMA has further stated that unless the tax is repealed, it will “stifle innovation, harm patient care, and weaken the position of the United States as the global leader in medical device innovation.”[1]

Despite such ominous predictions, investors have not been deterred and in fact, put more money into medical device companies in 2012 than in 2010, or any year in the decade between 1995 and 2005. Additionally, venture capitalist disbursements to medical device companies within the U.S. shot up from $440 million to $581 million between the third and fourth quarter of last year, which amounts to a 32 percent increase.[2]

As the above figures suggest, money continues to be poured into this field. The first half of 2013 was surfeit with reports of debt and equity transactions of all sizes within the medical device space, a few of which are detailed below:

  • Valeritas — the maker of the V-Go insulin delivery device — secured debt financing from Capital Royalty LP in the amount of $100 million to fund commercialization of the V-Go.
  • TVA Medical — an Austin, Texas-based medical device company developing minimally invasive therapies for end-stage renal disease — raised $9.5 million in Series B financing from S3 Ventures, Tristar Technology Ventures and Santé Ventures.
  • iRhythm Technologies Inc. — a developer of diagnostic monitoring solutions that facilitate early diagnosis and treatment decisions — secured $16 million in Series D venture financing led by Norwest Venture Partners.
  • Topera Inc. — the maker of the RhythmView 3D Electrophysiological Mapping System — secured $25M in Series C financing led by New Enterprise Associates.
  • Vapotherm — a manufacturer of advanced respiratory care devices — closed a $29 million financing round led by 3x5 Special Opportunity Fund LP. Other investors included Morgenthaler Venture Partners LP, GE Asset Management, Kaiser Permanente, Integral Capital Partners, QuestMark Partners and Cross Creek Capital.

For those medical devices companies that experience financial strain as a result of the tax, one option companies have pursued is passing the cost along to their customers, such as hospitals. Some of the manufacturers that explicitly include the 2.3 percent tax on customer invoices include Solar Biologicals, a lab supply company; Cadwell Laboratories, a diagnostic and monitoring products company; and Condonic Heights, a medical imaging and information management device company.[3]

Not surprisingly, the hospitals being asked to absorb the extra cost vehemently oppose the practice. In March 2011, the Healthcare Supply Chain Association, the American Hospital Association, the Federation of American Hospitals, and the Catholic Health Association wrote a joint letter to the Internal Revenue Service, imploring them to prohibit medical device companies from passing on the costs of the excise tax by imposing a “no pass-through rule.”[4]

Although the IRS refused to approve the rule, hospitals and health organizations continue to fight the cost-passing practice. HSCA, for example, has urged medical device manufacturers to end the cost-shifting and hospital partners to avoid contracting with manufacturers that engage in cost-shifting.

Rise of Medical Technology Investments

As the medical device business continues to thrive generally, activity in certain subsets of the medical device field has surged. Mobile health care technology, in particular, has gained the attention of doctors, patients and private equity investors alike.

Mobile health care, referred to colloquially as “mHealth,” has been touted as the next big thing in health care, with Kathleen Sebelius, secretary of the U.S.Department of Health and Human Services, declaring mobile health care “the biggest technology breakthrough of our time.”[5]

On the private equity side of mHealth, health care information technology investments totaled $766 million in 2011, an increase of 78 percent from the year before. Already, mobile health applications have a significant presence in the market with approximately 97,000 mobile health applications offered in major app stores as of March 2013.[6]

Also, according to PricewaterhouseCoopers, 60 percent of patients and physicians — surveyed from 10 countries including the United States — believe that mHealth applications will be adopted widely in their respective countries.[7]

As mobile technology continues to grow, investors and developers alike must be aware of relevant regulations, some of which, discussed below, may present hurdles to introducing these apps to the market.

Regulatory Hurdles for mHealth Companies

Companies producing more sophisticated mobile medical devices may face U.S.Food and Drug Administration regulatory hurdles. Under FDA regulation, medical devices are separated into three different categories for the purpose of determining the proper level of regulation. Class I devices are low-risk products (e.g., tongue depressors or ice packs), Class II devices are intermediate-risk products (e.g., powered wheelchairs), and Class III devices are high-risk products (e.g., implantable pacemakers).

Each medical device that presents a substantial risk of danger to patients must receive FDA approval before being marketed in the United States. While low-risk medical devices are exempt from premarket review and can be marketed following registration with the FDA, moderate and high-risk devices must meet both premarket and postmarket requirements according to their respective levels of potential risk to consumers.[8]

Although some mHealth devices are designed to perform more sophisticated functions, many are akin to Class I medical devices, 95 percent of which are exempt from the regulatory process.[9] FDA representatives have issued assurances that apps like calorie counters, which carry minimal risk, fall outside the scope of what the FDA hopes to regulate.

 Christy Foreman, director of the FDA’s Office of Device Evaluation, clarified that the FDA’s targets for regulation are mobile apps that can more easily compromise patient well-being. For example, a mobile app controlling a CT scanner or a drug infusion pump could pose more substantial risks to patients and would therefore be more likely to be subject to regulation.[10]

While FDA regulations may first appear insurmountable for companies unfamiliar with the regulatory process, they will not be daunted for long. In fact, many mobile medical apps have already received FDA approval. For example, AliveCor — a Class II mobile device that attaches to the back of smartphones and transforms them into electrocardiogram devices — was granted 510k clearance in November last year.

Other Considerations Affecting Investment

FDA regulation of medical devices remains a challenge for medical device companies, but it has not necessarily prevented smaller medical device companies from introducing their products to market.

While the costs of running clinical trials and satisfying other regulatory conditions may be prohibitively expensive for smaller companies to navigate alone, these companies can work in tandem with larger companies. This arrangement is also attractive for larger medical device companies that may not want to invent new products, and instead, look to acquisitions as the primary vehicle for obtaining marketable products. According to a 2012 Congressional Research Service report, although the largest medical device companies make the highest number of sales, small device companies often play a larger role in early development and innovation.[11]

With the rise in joint development and collaboration between different-sized companies, small or startup medical device companies may initially appear even more attractive to investors, but venture capitalists should beware of future resale/recap risk.

Large companies that gain their products through acquisition may be averse to acquiring venture or private equity-backed products — in part because these targets are deemed too expensive. As one commentator put it, these large companies are looking for “products, not companies,” and they fear that venture-backed pickings will be more difficult to integrate into their own infrastructure.[12]

It is unsurprising then that venture-backed medical device targets have become far more expensive to acquire, as venture capital firms are shelling out larger investments on the front end.

At a 2011 conference, Jan Garfinkle, managing director of Arboretum Ventures, stated that in 2008 or 2009, venture capital firms could invest more modest sums of money to develop products for strategic partners, but in 2011, the typical investment was closer to $20 million.

For example, Garfinkle shared that in a past deal, Arboretum Ventures and other syndicates expected to invest around $5 million in VasoNova (a catheter business), but ended up pouring $19 million into the company. Garfinkle also stated that the timeline for selling the business was much longer than expected, but that the investment eventually turned a profit — selling for approximately $55 million.[13]

With all of these factors influencing the profitability of private equity and venture capital activity in the medical device industry, it seems clear that the impact of the medical device excise tax is not the end of the story. Although changing market factors may require industry players to adjust accordingly, investing in medical devices remains a viable option for the right investors, despite the accompanying risks.