The Law and Other Anomalies

During the time between year-end and the annual meeting, public boards are planning director elections, effecting audit review to conclude the annual financials, addressing 10K and proxy matters, evaluating shareholder proxy and other proposals from activists, and conducting intensified committee meetings which inevitably follow fiscal year-end. Key board issues for this period were highlighted at the January 13^th breakfast meeting of the New England Chapter of the National Association of Corporate Directors, where a panel of financial, legal and shareholder relations experts summarized the current state of play.

From a shareholder communications standpoint, directors shall be focusing on an evaluation of board members standing for reelection. Broader disclosures should be considered, aside from simply reciting education and work background. Consider proactive disclosure with respect to the reason that each individual has been elected to your board: diversity, different skill sets, domain experience, etc.

Management should be prepared to engage activist or institutional shareholders which are likely to have questions after year-end. Have you reviewed your corporate strategy against performance last year? How do you answer questions about your plans for capital expenditure and, particularly, use of excess cash which many corporations have been collecting? Is a share repurchase program actually the best use of company money, given recent analyses that suggest that shareholder value is not thereby enhanced, or is it simply a sign of lack of imagination as to how else to apply the capital?

This is also a good time to review your crisis plan, including identification of inside and outside teams, coverage of social media, and review of “hidden website” content which has been prepared to meet various crisis scenarios.

From a financial control standpoint, boards sometimes find themselves on a somewhat different wavelength from internal audit, which may be directing its attention to operational efficiency. The board’s role is to assure robust financial reporting. Has your board reached out to the internal audit function to make clear that internal financial control is to be given high priority? Has the board engaged its audit committee, or its risk committee, for a year-end review and projection of risks in context?

Other currently hot board topics include: should your CEO be your board chair or should the board chair position be independent (does your board want to undertake a renegotiation of the CEO contract which likely says that the CEO also is to serve as chair?); what is your board’s approach to term limits or “aging out” of directors (might your board be reviewing the European approach which views “independence” holistically, and suggest that ten years of service by definition renders any board member no longer “independent” in a meaningful way).

There will follow a post on the so-called SDX protocol, an organized effort to improve institutional investor access to independent board members.

What are the trends in funding early stage life science companies? A panel of seven investors speculated on the 2015 outlook, at a December 10^th Venture Summit held in Dedham yesterday.

Riding an increasingly robust funding of transactions at the seed and A-round levels, the investors anticipate continued strong deal flow, driven by a reduction in the funding generally sought by start-ups. They speculated that this reduction was driven by more refined pitches and reliance on internet tools that make start-ups more flexible and efficient. Not mentioned, but perhaps another factor, is the sea change in the manner in which bio and bio-pharma companies are developing their products, in reaction to the massive capital requirements which caused negative investor reaction several years ago.

Hot areas anticipated are oncology, ocular disease, orphan diseases and, in the long run, genetic modification. One panelist, interestingly, suggested that capital is being scared off mass drug development because of the risks of liability arising from continued application of drugs to larger numbers of people over a multi-year period.

What company attributes are attracting capital these days? Robust teams. Proof of recurring revenue. A crisp story presentation. Avoidance of undue complexity (blamed on the lawyers, of course). And, although it can come in many forms, that elusive quality known as “traction.”

Over the last few years, medical device companies have learned that in order to get financing at any level it is not only necessary to establish efficacy and potential economic benefits, but also necessary to understand a strategy for obtaining reimbursement for these benefits. A medical device company, to obtain financing, must show value to the party making the payment, not to another party in the use of the technology.

At MassMEDIC’s November 7^th conference discussing markets for medical devices, it was suggested that one way to prove efficacy might be to target a smaller cohort notwithstanding the fact that one’s device might have general applicability. Proof of efficacy in the smaller cohort, and obtaining a reimbursement code, may be easier if focus is narrowed.

Noting that the United States is an outlier in the world’s healthcare universe, spending a disproportionate amount per person on healthcare, it was also noted that the value of a medical device in the United States market is higher by definition. Spending one day in a Unites States hospital is three or four times more expensive than one day in a European hospital. The United States also has an unusual model in that doctors are paid separately, which increases the likelihood that individual doctors will support new devices.

Some key take-aways with respect to the reimbursement system in the United States:

Reimbursement depends upon the setting, with different codes and different rates for the same procedure dependent upon whether that procedure is performed in a doctor’s office, a hospital ambulatory setting, or a hospital inpatient setting.

In the coming year, new ICD-10 codes, with far greater granularity, will be introduced in the United States, with mandatory usage beginning October 1, 2015. This will have huge impact on hospitals. (Coding for doctor offices and for outpatient treatment will continue to be under the CPT system.)

For a variety of reasons, many medical devices these days are first introduced in Europe, in the UK or Germany or Nordic countries. Most of Europe is on a single payer system. We thus have an anomaly: the value of medical devices is highest in the United States but the preferred path of introduction nonetheless is moving toward Europe in any event, by reason of ease of regulatory clearance and obtaining payment.

At the MassMEDIC conference in Boston last Friday, Neil Oboroi of BOA/Merrill Lynch, an investment banker based in New York, discussed the M&A market for healthcare in general and medical devices in particular. As befits an investment banker, he was enthused with the increasing volume of healthcare M&A, and furthermore had statistics to demonstrate a positive link between M&A activity and stock price.

His belief is that stocks of companies effecting acquisitions in the life sciences out-perform their peer group (companies not undertaking M&A transactions) by 8% based upon share value. He predicts that consolidations in life science will continue, with acquirors seeking return on investment capital as opposed to looking only at earnings per share impact.

Many of the larger deals in the life sciences involved devices and diagnostics. Valuations, which peaked at about five times forward revenues in 2007 and fell to about three times in the ensuing years, are now up ticking again, in part because of the prevalence of cross-border transactions.

He also noted that larger publicly traded medical device companies were now trading at a little bit over twenty-three times forward earnings, down from approximately thirty-two times forward earnings a decade ago; so market multiples are falling. He also noted that many of the larger companies that had undertaken M&A were now choosing to report based on earnings per share, in addition to using a GAAP standard; earnings per share reporting allows easier comparison of companies, particularly as they are emerging.

Oboroi also touched upon inversion transactions, noting that earnings always were taxed where earned. The real play, made harder by recent tax changes, is the ability to utilize offshore cash domestically; the only way today to effect an inversion is through an M&A transaction.

There was also a discussion of the life science new issuance market, which is extremely robust and on a pace to equal or surpass the previous heights of the 2007 IPO market. The criteria for going public with a device company today: hard revenues, with a $25,000,000 to $50,000,000 minimum run rate, a growth curve, and a robust management team. The IPO market was viewed as synergistic with and consistent with the strong med tech M&A market.

The idea that venture capital has returned to the marketplace in order to finance life science companies, and particularly device companies, is simply not true, says Dr. Tom Fogarty, world renowned inventor and entrepreneur and most recently founder of the Fogarty Institute for Innovation, where he develops life science companies, in Mountainview, California.

Actually, Dr. Fogarty’s description of the non-presence of venture capital in the marketplace was a bit more descriptive, but I am not quite sure what the standards are for making reference to bovine excrement.  He delivered his remarks at today’s Medtech Showcase conducted in Boston by MassMEDIC.

Other gems:

            The problem with FDA clearance procedures is that the examiners belong to a union and do what they want to do.

            Corporate investment in life science is impeded in that large corporate investors give new technology to their own in-house people to evaluate; new technology that is better than in-house technology will not get funded on that model.

            Academics are no good at commercializing their technology, particularly in medicine.

Next week I will post a series of blogs on other take-aways from the MassMEDIC Showcase, covering a variety of subjects (new funding available through Massachusetts Life Science Center; the state of medical device M&A; the state of medical device IPOs; relative strategies for med device reimbursement in the United States as compared to Europe; a fascinating panel on why medical devices cannot seem to attract investment capital as easily as biotech).