A venture capitalist considering an investment in a medical technology company is making a long-term bet on a high-risk/high-reward business. Assessing a company in this sector involves more than the standard areas of due diligence review such as finance, litigation and corporate structure. Medical technology investigations also require focused review in key areas—including intellectual property, regulatory and strategic alliances—to accurately evaluate an investment opportunity.
Any efficient and effective due diligence review includes an analysis of the intellectual property (IP), with the focus and depth of the analysis being proportional to the importance of the IP to the company's value and/or success. In the case of a medical technology company, the IP is almost always vital. While patents and trade secrets will be the focus of the following discussion, copyrights and trademarks must also be considered in appropriate cases.
An IP analysis must examine both the scope and breadth of the company's IP protection and the freedom of the company to operate in its intended market. The analysis must also start with a strong understanding of the company's products and/or services, its marketing plan and its long-term business goals.
Analyzing a Company's IP Protection. After examining the products/services and business strategy of the company, the company's protection of its technology is generally analyzed in two steps: (1) a "forensic" examination, and (2) a substantive examination.
The forensic examination is essentially a cataloging of the company's IP—identifying and creating a list of IP and identifying any gaps therein. The cataloging includes a review of the status and details (such as ownership—including a review of assignments as discussed further below—inventorship, etc.) of all IP, including patents and applications, trade secrets, confidentiality and license agreements, trademarks and copyrights.
The substantive examination is a more intensive, in-depth examination of the depth and scope of the existing patents, applications and license agreements. For the patents and applications, this involves a review of scope—including the essential analysis of whether the patents cover the company's products/services—validity and enforceability. For trade secrets, this can include a review of the company's trade secret maintenance procedures. Any holes in the IP must be identified and analyzed to determine if any existing issues can be addressed or are deal killers.
Freedom to Operate Analysis. An analysis of relevant third-party patents is a key component of any emerging company due diligence. As any venture capitalist knows, a strong portfolio of patents and patent applications is important, and perhaps essential, but that portfolio has very little value if the company does not have freedom to operate (FTO—the freedom to make, use or sell its products or services) because of one or more third-party patents that may potentially block the company from making, using or selling its products and/or services. The FTO analysis typically includes a search and analysis of relevant third-party patents in light of the company's key products and services.
Noncompetes and Assignment of Inventions
With any company, it is critical to review the employment status of the key employees, which includes management and technical employees.
Competition Restrictions. Quality due diligence on these individuals requires reviewing their prior employment agreements to ensure there are no competition restriction provisions that prevent the individual from working with the company.
Assignment of Inventions. Typically, employees and consultants sign invention assignment agreements when they join a company that require the individual to disclose inventions with prior companies and assign rights in certain past and future inventions, trade secrets and other proprietary rights to the company. Under these agreements, individuals also may exclude certain pre-existing inventions from assignment to the company. A quality due diligence review will include a detailed review of both the invention assignment agreements with the target company to ensure the company acquires all on-the-job intellectual property and that no prior necessary intellectual property was excluded from an invention assignment, as well as a review of the employees' prior invention assignment agreements, coupled with targeted employee interviews, to ensure that no intellectual property that was assigned to another company is needed or used in the company's business.
Regulatory review of a medical technology company's products or proposed products can lay the groundwork for a successful investment. Understanding the regulatory approval process and timeline for both primary products, as well as product modifications, ensures an investor can properly assess the company's cash needs and directly impacts a company's valuation. In the medical technology industry, there are numerous regulatory issues to properly assess for a successful transaction:
Regulatory Approvals. Understanding a company's U.S. and European product approval process requires careful file examination. An investor should discuss and stress test management's expectations and appreciation for the approval process, including their experience obtaining CE, 510(k) or premarket approval.
Current Compliance Status. Often, the key regulatory review is focused on evaluating the company's current FDA compliance status. For a company that manufactures a device, this often requires site visits to assess facility compliance.
Labeling Review. Careful reviews of approved indications for use, coupled with a comparison to current promotional materials, ensures claims made in promotional materials are consistent with the indications for use specified in regulatory filings. If non-approved functionalities are incorporated into promotional materials without regulatory review, a company could face fines, litigation and loss of regulatory approval.
Fraud and Abuse Compliance. Companies have varying levels of sophistication about compliance with the array of federal and state laws designed to prevent fraud and abuse in health care, such as the federal anti-kickback statute and various state laws that regulate relationships with referral sources such as physicians and hospitals. An investor should consider whether the company has a compliance program in place; confirm it has complied with state laws requiring reports of payments to physicians; ask whether the company is or has been under investigation by any state or federal regulatory agency; and determine whether the company or any director, officer, owner or employee has been excluded or debarred from participation in federal programs, including Medicare or Medicaid. Because relationships with physicians and other referral sources pose significant risk, an investor should review the company's practices in entering into consulting, advisory board, research and other arrangements under which physicians receive compensation, including whether the company complies with the AdvaMed Code of Ethics on Interactions with Health Care Professionals.
Having a high-quality product and a great marketing strategy does not guarantee the company's success. It is critical that the company's products are reimbursable by public and private health insurers. If the technology is already on the market, investors must understand how payment is made, the costs of the company's reimbursement structure and the company's reimbursement success. If the technology is not yet available for sale, it is critical to understand the company's reimbursement strategy and its feasibility.
Joint Ventures and Strategic Alliances
Emerging medical technology companies often focus on product development and FDA approval and will use third parties to engineer, manufacture, distribute and obtain reimbursement for their products. The agreements structuring these arrangements are often complex and industry- or segment-specific. A thorough due diligence review will include a detailed review of these arrangements to ensure the investors understand the terms and payment arrangements, as well as the renewal and termination provisions of these agreements.
ConclusionInvestments in medical technology companies often prove very rewarding for investors. Given the long-term nature of these investments and the intensive capital needs of these businesses, it is critical that an investor dig deep in its due diligence.