“Welcome to the end of the easy money, the end of easy liquidity, corporate risk reduction, slower adoption, less capital available for startups, lower valuations and tougher business development opportunities.”Charles Ganz, Founder/CEO, The Center for Innovation Commercialization LLC
The Game of Thrones reference in the title of this post seemed appropriate because the latest numbers for the third quarter of 2022 show that digital health funding fell 36% quarter-over-quarter and 72% from its all-time high set in the second quarter of 2021. It appears that the halcyon days of easy access to money, inflated company valuations, and continuous health system investments are over. That paints a bleak picture for 2023 and maybe longer for startups looking to grow their businesses.
The macro market trends driving this downturn include increased interest rates, a limited market for initial public offerings, lower public market multiples, slower enterprise purchasing, and preparation for the risk of a recession. Because no one knew how to price a deal in a downward market during Q3, most investors chose to wait until the market stabilized. Another critical reason that digital health’s Q3 funding numbers were so low is because venture capitalists are dealing with more bloated digital health portfolios than they’ve ever had, according to Marissa Moore, an investor with OMERS. This is because there was a record-breaking flurry of investments in the space during 2020 and 2021.
These sobering statistics were underscored in two Q3 2022 reports from CB Insights and Rock Health. Rock Health identified a few key themes that have emerged throughout Q3: 1) smaller checks across the board, 2) a focus on early-stage funding, 3) reprioritization of technology investments, and 4) an exit market that’s beginning to thaw. They see investors looking for early-stage, complementary businesses to round out their portfolios. As such, 2022’s funding data to date offers a unique opportunity to examine investment patterns by value proposition, therapeutic area, and technology type as bellwethers of digital health growth areas for quarters to come. They break those out in the chart below:
In addition to the challenges on the investor side of the equation, digital health startups have to face new realities on the buyer side as well. Healthcare systems in the U.S. have had a challenging year, and they are on track for their worst financial year in decades. According to an analysis by Kaufman Hall, optimistic projections for the rest of the year indicate margins will be down 37% relative to pre-pandemic levels. More than half of hospitals are projected to have negative margins through 2022. Projections for the remainder of the year demonstrate an increase in hospitals with negative margins relative to pre-pandemic levels, to 53%. Expenses are projected to increase throughout the rest of 2022, leading to an increase of nearly $135 billion over 2021 levels. Labor expenses are projected to increase by $86 billion, while non-labor expenses are projected to increase by $49 billion. Ultimately, U.S. hospitals are likely to face billions of dollars in losses in 2022 under both optimistic and pessimistic models, which would result in the most challenging year for hospitals and health systems since the beginning of the pandemic with no foreseeable federal support.
Payment rates will eventually adjust to rising costs, which are likely to occur slowly and unevenly, according to the report. Medicare rates, adjusted annually based on inflation, are projected to undershoot hospital costs and are expected to widen the gap between costs and payments. Economic uncertainty and the threat of recession are expected to create continued disruptions in patient volumes. Combined, these factors suggest that the current financial pressures are unlikely to resolve in the short term.
Despite these formidable headwinds, I believe there’s still an opportunity for startups to demonstrate their impact and clinical value, given the nation’s healthcare challenges aren’t likely going away anytime soon. But for digital health startups to be successful in the current economic landscape, they need to put an increased emphasis on showing how they deliver value to organizations. It is no longer sufficient to tout statistics on usage or engagement — instead, companies need to give investors a clear picture of the ROI. In my advisory capacity with Digital Health startups, here are the points I’m emphasizing in developing their approach to this turbulent market:
- Getting access to capital will be difficult for the foreseeable future. Fine-tune your investor pitch to focus on how your product or service delivers value to the end user. And back the value proposition up with real-world data. The digital health segments that have received the most attention include appointment scheduling, logistics, virtual care, and the development of at-home testing kits. Make sure you can answer the following questions:
- Is the value proposition interesting enough? Does it create impact?
- Is the value proposition differentiated from other products existing in the market?
- Is the team capable of developing the company?
- Does the company have first customers or a proven intent from customers to buy the service/product?
- Investors need to know that this is a 10-year (minimum) project for you and your team. Commit by showing your development plans broken down by milestones. E.g., Year 1: we will accomplish X, Year 5: we will achieve Y, etc.
- Point solution or platform solution? – With investors looking to mitigate risk, they’ll want to see “what is Chapter 2 for your company?” Is this a “one-trick pony”? Or do they have an achievable vision for developing the solution.
- Data integration is a key requirement – Integrating any data from your product or service into the electronic health record is essential.
- Understand that the sales cycle for digital health solutions will get longer. Look at the financial numbers for health systems above, and you can see why there’s not a lot of available capital for “nice to have” or “want to have” solutions.
- Understand where health systems are focused these days. My former Sg2 colleague Bill Woodson who has been in board meetings around the country characterizes the current environment as “the tyranny of the present” where health systems have to focus on staffing, margins, length of stay, and capacity management to “right the ship” before they return to their short and long term digital health strategic plans.
- What are the top three priorities for health systems these days? Staffing, staffing, and staffing. If you have a digital solution that makes a frontline healthcare worker’s job easier or expands the ability of a single individual to provide care to more patients, you can get someone’s attention.
- Solutions that address accessibility, affordability, and efficiency are valued. These solutions are a way to uncouple healthcare services from the traditional hospital setting and bring care to patients regardless of where they are.
2023 will undoubtedly bring change as the macroenvironment shifts, valuations and multiples reset downward, and the mix of prominent and emerging digital health sectors undergoes rapid adjustment. But most importantly, the need for the digital transformation of healthcare has not lessened; if anything, it’s become more pronounced. As long as that need exists, there will be great opportunities to invest in companies driving that shift.