Digital health funding in the last 12 months has stood in stark contrast to the overblown valuations and feverish rush of investment dollars that the sector grew accustomed to in 2020 and 2021. With the recent collapse of Silicon Valley Bank, the dark cloud hanging about the digital health sector’s funding environment could get even stormier. The institution was known for venture debt and gave many startups a hopeful path forward for financing, so its fall will likely have serious implications when it comes to healthcare startups’ innovation and funding.

So how are venture capitalists reacting to this? That was the topic of discussion during a panel moderated by Arundhati Parmar, MedCity News’ editor-in-chief, on Tuesday at ViVE, a healthcare innovation conference in Nashville.

Parmar presented the panel of four VCs with a quote taken from an op-ed recently published in The Information by Hemant Taneja, managing director of General Catalyst:

“The run on SVB was a textbook result of the myopia and egoism that has swallowed the venture capital industry whole.”

What happened with SVB was a “tragedy of the commons,” responded Lee Shapiro, managing partner at 7wireVentures.

“We in the venture capital community — not all of us, I must say, but many — ended up causing the failure that we were worried would happen by counseling companies to move their money out, and that precipitated the run on the bank,” he declared.

Emily Melton, managing partner at Threshold Ventures, agreed. She pointed out that the venture community, founders and commercial banks are all part of an ecosystem and are codependent.

In Melton’s view, what happened with SVB was a classic prisoner’s dilemma. 

“Everyone tried to take care of themselves without looking at the overall impact on the ecosystem. This is something that we now have to really think through and recognize and do differently,” she said.

She also argued that many of the VCs pulling money out of SVB were young people and/or heavily influenced by panic on Twitter. Information is moving faster than ever on social media, but it’s also less nuanced, Melton pointed out. This doesn’t help VCs when they need to pause, sit down and react thoughtfully in a volatile market.

By agreeing with Taneja’s comments, Melton and Shapiro took part in the internal criticism happening in the VC industry. But the next quote Parmar presented didn’t come from inside the VC community, but rather a Slate article written by journalist Edward Ongweso Jr.

For over a decade, low-interest rates have allowed venture capitalists to accumulate huge funds to give increasingly unprofitable firms with unrealistic business models increasingly larger valuations  — one 2021 analysis found that not only were 90 percent of U.S. startups that were valued over $1 billion unprofitable, but that most would remain so.

Panelists were also faced with the chart below, which shows just two out 17 public health tech companies being profitable.

A key reason there are so many red numbers on that chart is because of the quixotic valuations that digital health companies have had in the past few years, said Richard Mulry, president and CEO of Northwell Holdings.

“I think the environment we’re in now is going to a really more realistic view. Those valuations will be less frothy, and I think some of the larger strategics and where they’re sitting in the market now have made everyone just a little bit more sober about the dynamic for how we got to that point and how to avoid it in the future,” he said.

When the public market and M&A world was valuing companies in such an exaggerated manner, growth rates were being prioritized above all else, according to Maverick Ventures Managing Partner Ambar Bhattacharyya.

“Profitability was an afterthought, so long as the business model had a potential to work,” he explained during the panel.

The advice given by Bhattacharyya and many other VCs was that the way to maximize enterprise value was to maximize growth, especially when the battle for new customers and employees is rife with fierce competition both from other startups and established incumbents. 

But VCs have moved away from that thinking in the past year, he said. When you look at companies in the public market that have the highest multiples, they tend to be “Rule of 40” companies, meaning their combined growth rate and profit margin exceeds 40%, Bhattacharyya explained. 

“But if you look at the subset of companies in the Rule of 40 that have the highest revenue multiples, they’re the ones that are cash flow positive. And so all of us kind of look at that data and say how do you maximize enterprise value for all people? That’s now the playbook. So we’ve all transitioned to that,” he declared.

The fact that the market has switched its focus from growth to value doesn’t mean all hope is lost. In fact, Melton pushed back against the prediction that healthcare startups valued over $1 billion would remain unprofitable.

“It’s not just about revenue. It’s about quality of revenue and where there is real leverage in the model where you can actually drive those better outcomes at lower cost and increase access,” she said.

The panelists argued that startups will be able to build high quality revenue streams if they’re smart and offered several pieces of advice about what startups need to know in this changing market.

Shapiro’s number one piece of advice for startup founders is to recognize that valuations are time-bound. To succeed, they need to be “realistic and opportunistic,” he declared.

“I think that you can’t say ‘But valuations were at this level just a year ago!’ We are where we are, and if you need to raise money, you raise it at the time you’re in. Raise the money that you need, find the right partnerships, think about other ways to get to scale, but you shouldn’t be thinking about where it could have been,” Shapiro explained.

In the same spirit of moving forward, Bhattacharyya encouraged founders to always keep an eye open for opportunities in the market and be wary of focusing too much on conservatism.

He pointed out that the whole industry is thinking about profitability and picking their battles carefully. The market is dominated by “a defensive playbook” now, in his view.

“My advice to founders is to always have that offensive playbook at hand too, because the next two years are equally as unpredictable. Everyone is going to retreat and focus on the core, and that may create brand new opportunities that may not have been on the table to actually launch a new product, gain share and scale,” Bhattacharyya explained.

Mulry had a different nugget of wisdom to share. He cautioned against “founder syndrome,” which refers to a founder’s reluctance or inability to move away from the idealistic vision of the company they had when they started it years ago. 

Founders can fall into this trap, and it’s understandable why. They were the ones who had the original idea for the company, and they were the ones who spent their life building it. But Mulry pointed out that there often comes a point when it’s a better idea to hand the reins over and let someone else be CEO, while still participating in the company in a meaningful way. He said some founders’ unwillingness to accept this has prevented several of the companies that Northwell Holdings has invested in from “becoming wildly successful.”

The VCs all agreed that there’s still plenty of room for startups to thrive in the digital health sector. They just think founders are going to have to act with a lot more intentionality and realism in the coming years.

Photo source: HLTH