Digital health needs more creative financing options
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Exploring outside of healthcare
One of my New Year’s resolutions is to be happier. The second is to spend some time outside of healthcare. These are related.
There are two areas in particular I’m trying to learn about: company organization and alternative financing structures. I have mostly spent time in healthcare startup land, which tends to be very homogenous in how it thinks about this - C-corp organizations with a top down hierarchy that mostly finance themselves via equity and growth at all costs. We’re seeing the downsides of this now, so I’m curious if alternatives might be useful.
Now, I’m out exploring the non-startup jungles like a young Indian Jones (not a typo) to learn how the rest of the world works.
Today is part 1 - going through a few alternative financing types. This is all very new for me too, so don’t take anything here as gospel. I am still learning, don’t hurt me!!!!
Does venture work for healthcare?
Before looking at the alternatives, I think it’s worth asking whether venture capital has been working for digital health startups. Venture capital and equity financing are tools that have worked well for companies with clear forms of defensibility, high margins at scale, potentially long R&D timelines (e.g. hard sciences), and good deck designers.
I think the reality is that most healthcare companies have portions of this, but venture has become a blunt tool for digital health startups, especially when interest rates were low and raising rounds via equity was the fastest and easiest way to capitalize a company. It’s a form of financing that’s good for companies that gain operating leverage as the company grows so they can achieve non-linear growth, especially relative to the cost of inputs. But by definition, services scale pretty linearly with the company.
So is venture good for digital health companies, especially ones that rely heavily on services? There are a few good pieces that take the side that tech-enabled services in healthcare are generally venture investable. Greycroft talks about it here, Bessemer talks about it along with some very useful benchmarks here, and several investors from 7Wire, OMERS, and Flare have their take on it here.
I think they make good cases around areas where margins can expand, where you can have longer term relationships with patients or payers (and therefore more total $), etc. But a few things I wonder:
- One of the big sells of tech-enabled services companies is that the experience is better for patients, which is one of the reasons engagement is higher, patients come back, etc. IMO when services companies scale, their quality degrades and erodes this advantage - significantly if they scale too quickly. My local One Medical doesn’t even put the fruit slices in the waiting room water anymore. It makes me wonder if there are actually some negative network effects to healthcare services.
- It takes a very, very long time to build a brand that will rival the large, traditional institutions that most of these companies are competing with. This is especially true in a risk-averse purchase like healthcare. And, as the technology to build these companies becomes easier and off-the-shelf, existing brands with distribution + brand can very quickly come to compete (e.g. Hospital for Special Surgery launching their own telemedicine musculoskeletal program).
- In general, I’m skeptical of how much “efficiency” is actually gained by software at a certain size of company. In fact, I think when an org becomes large enough it may even become LESS efficient because of the number of products, contracts, geographies, and general variability that comes with the business and therefore people in the chain of management to deal with that. In software-only companies, the per employee unit of productivity increases with the size of the business. In tech-enabled services, I don’t think that’s true and might actually be the inverse. Talk to any healthcare ops person about processes at a Series B health services startup and the tears basically come out by themselves.
- I think company size is artificially constrained in 3 dimensions. The supply of clinicians that can work for your care model, where we’re seeing the constraints now show up in labor costs. The in-person components of the business (warehouses, brick & mortar clinics, etc.), which either limit expansion into markets or the types of services you can offer. And payer willingness to reimburse, which can increase to a certain point and then stops growing. Together, this forces a relatively linear scaling in the business.
- Timelines for everything in healthcare are much longer, so the question becomes whether a dollar of equity invested in a healthcare services company performs well relative to other places it could be invested. We’re talking business models that take 8-10 years before they see maturity, where the money is pretty much locked up, and require a ton of capital on the way up to actually get to an exit. And on top of that, it's a sector with more regulatory risk in general (shoutout to all the companies dependent on risk-adjustment). If you’re an investor debating between the different places to put money, even if you CAN make a return in healthcare…is it the logical place when you take into account time and opportunity cost of deploying that capital? I know a few investors on TikTok that can get you 10x your money in 3 months with this one weird trick (robbery).
To be clear, I’m an advocate of companies including services as part of their business and don’t think they should shy away from it.
But my hunch is that it’s going to be very hard to get venture style returns from (non life sciences) healthcare companies with large services components, especially via straight equity financing. We just haven’t really figured out the right financing mechanism for companies that need money upfront but will only be around 30-40% margin at scale after 10+ years and maybe even need to remain subscale.
But I don’t think that means it’s not possible to make great returns in healthcare. We just might need to get more creative with the financing.
Remember, venture capital is a very tiny asset class within private markets. And even smaller in the context of public markets. And even smaller in the context of your mom.
Outside of tech and startup land, businesses get started and grow with a wide variety of financing instruments, of which equity is only one tool. Could any of these be used for services startups? Or in general, starting new, small businesses in healthcare with the intention of staying small but profitable? (Btw “profitable” means you make more money than you spend, for you startup folks 😉)
- Debt - I’m not going to pretend I know a lot about debt. VCs will tell you it’s scary and don’t use it. But VCs are also not about that mfin’ life.
Companies will sometimes use debt or credit to finance their business. This is especially good for businesses that need access to a pool of capital just to be operational even if it’s not on their balance sheets (e.g. a health insurance company), or are buying some specific fixed cost item (e.g. imaging equipment). And in general, it’s much better for businesses that have a clear path to generating profit and can start paying that debt down.
Debt can also become specific to a type of business. Medical practice loans are specific to clinicians who can generally get better rates, faster money, and more flexible repayment plans because of their earning potential + business income stability. Venture debt loans are more specific to startups with good investors who (presumably) are going to be able to raise more equity later and frequently have some warrants/options to buy equity for cheaper later, too. Tech-enabled services companies have a risk that lives somewhere in between these and now probably have enough data to better underwrite them. Is there a new debt product to be built here?
There are obvious downsides to debt - you need to keep paying it down or it’ll consume you, it requires collateral, etc. For certain kinds of businesses, it can be really helpful; for other kinds of business it can fuck up your whole shit up.
- Supply Chain Financing - A very simple version of supply chain finance: I produce widgets. Your business bulk purchase widgets from me. In most cases like this, you agree to pay my invoice within 30 or 90 days (depending on how much leverage you have). I am now stuck waiting for that money, but at the same time, I need money to produce a new batch of widgets. Supply chain financing fills in the gap for this short-term need of capital by giving me some money (and charges a fee).
In healthcare, there is a delay on literally every payment. Your doctor waits months for the insurance company to pay. The pharmacy waits months for the PBM to pay. Providers in a value-based care arrangement won’t get adjusted until the end of the year to make money, and only if they’re doing well. But they still have to operate the business until that cash comes in.
I’m sure many of the businesses dealing with physical goods already do some smart things with invoicing and supply chain finance, but I wonder if there’s more opportunity to bring this to healthcare. If a practice has a history of doing well and getting end of year quality bonuses, by plugging into their EMR, couldn’t you underwrite them immediately and give them short-term loans to run the practice?
- Revenue-based financing - I recently invested in an immersive theater thing and thought it had a pretty interesting structure: 70% of net profits generated go to investors until they’re recouped, after which 20% of the net profits goes to the investors in perpetuity. When a business isn’t going to “exit”, it’s a different way to still entice investors. It’s a new theater production in New York, obviously it’s going to be a good investment…right?
There are other versions of this which change the % of revenue required to repay the loan. Some funds like Lighter Capital, Novel Capital, etc. already have some forms of this for companies that are generating revenue. Indie.vc also had an interesting structure, where it would get paid back 5x the initial investment unless the company exited, in which case it would convert to equity.
Tech-enabled services companies are interesting in that they don’t take a ton of money to get started anymore thanks to all the new off-the-shelf tooling you can use and they start generating relatively predictable revenue quickly. This might actually make them better fits for revenue-based financing?
- Succession Loans - Some companies want to create a succession plan between the current owners and current employees. One way to do this is via an Employee Stock Ownership Plan (ESOP) to buy out the company. Usually the way this happens is the owner takes out a “loan” that doesn’t actually give them cash upfront, which is then slowly repaid by business cash flow over time as it buys out their equity. If the business misses a payment to the owner, the owner can get their equity back. Nick Gray sold Museum Hack this way. Astor Wines recently also did this, so now the employees get to pretend like the NYU kids aren’t using fakes to get $6 bottles of wine.
The issue is that the owners have to wait to actually get the money, so it’s not super palatable for them. There’s also still a risk that the new employee-owners mess up the business so that it doesn’t generate the cash to pay the owner. A new wave of firms like Mosaic Capital partners have sprung up to give owners the cash upfront and then make the transition to employee ownership. I assume they either charge a fee or get money off the interest while the loan is being repaid.
This is particularly interesting to me when I think about things like private practice succession. Right now most doctors feel like the only succession plans they have are by selling to private equity or hospitals. This kind of financing might create an actual succession plan while keeping good talent within the practice itself, or even create a plan for physicians working at hospitals to transition out. Or if someone has a healthcare newsletter with no clear exit plan…
The thing about all of these kinds of financing is they’re complicated, and most pure equity investors don’t really want you to touch them. This might be because they’re worried that investors who live above them on the cap table will get repaid first. This could also be because taking this kind of financing signals that you couldn’t raise regular funding. Or it could be because of unknown extra dilution that comes with warrants, etc. It complicates something that should be easy.
I think smart companies and investors will lean into some of these more complex financing arrangements so that companies don’t have to take as much dilution and investors can still make money on “smaller” companies vs. pressuring all of them to become large. In healthcare, scaling past a certain revenue number is extremely hard, but at that point revenue can be pretty predictable which might make it a better fit for some of these other financing arrangements.
Maybe new successful funds in healthcare won’t look like venture alone - but will have lots of different financing tools at their disposal and target different return profiles. Idk just give me money and I’ll figure it out. I know one weird trick to 10x it.
Parting words and food for thought
Some final thoughts around this:
- I’ve been trying to find opportunities to write small checks into companies that are for-profit but are trying to optimize for something beyond just money (e.g. producing really high quality art, creating community spaces, etc.). I know a lot of peers that feel the same way. I wonder if there’s a way to band people like that together to invest in something in healthcare that fits this mold - e.g. if I had a primary care physician I really loved, could I syndicate a group to invest in their new office as a loan? I would also probably refer people to it, which is good for the business.
- I wonder if there’s room for a new accelerator that really just focuses on healthcare services businesses and connects them to financial instruments that are better fits for their business (along with the normal accelerator stuff). Y Combinator does a great job at what it does, but I wonder if their SAFE note + advice they give works better for pure software companies vs. the more complex healthcare services ones. Ease has a fellowship for doctors starting a practice, maybe there’s room for other versions of this to exist.
- Venture dollars were used to pretty expensively acquire patients + physicians. When these companies can no longer raise cheap equity, IMO the main beneficiary is going to be private equity and large company corp dev teams that use debt to start rolling up some of these assets together to either point them towards risk-based models or juice up their fee-for-service billing. You see some inklings of this already with Signify + Remedy merging via New Mountain Capital, only to be acquired by CVS. Interwell, Cricket, and Fresenius did some weird polyamorous 3-way merger in value-based kidney care.
- For what it’s worth, I don’t even know if this is limited to services in healthcare. A lot of companies had big returns for VCs where it’s still unclear if the business actually works or whether it’s a low-interest rate phenomenon (e.g. Uber). Just because something returned money to investors doesn’t mean the BUSINESS actually works. But it’s been hard to separate that in the last decade.
If you’ve been thinking through some of these issues or have actually implemented different forms of financing for your company, hit me up.
Part 2 will go through some different ways of organizing a company.
Nikhil aka. “sounding like a sophomore that just took the intro class for corporate finance”
P.S. Claims data 101 alpha is officially sold out! There are some seats left for healthcare marketing 101, though.
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Thanks to Elliot Cohen, Morgan Cheatham, Jay Rughani for taking a look at drafts.
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