Small Businesses have Big Impact on Device Market

7 January 2010 (Last Updated January 7th, 2010 18:30)

The recent economic gloom has led to a dramatic shift in the way small and medium sized enterprises source financing. GlobalData looks at the financial options available to SMEs in their battle to innovate and survive, as well as the opportunities for their larger counterparts to benefit from these new arrangements.

Small Businesses have Big Impact on Device Market

Small and medium enterprises (SMEs) have traditionally played a crucial role in the development of new products in the biotech and medical device industry. Because of their quick adaptability, ability to identify market niches and considerable innovative potential, these firms form an important component of the healthcare industry worldwide. Accounting for more than 50% of all pipeline products, they have a significant role in the future of the healthcare industry. Analysis of more than 4,000 products in the pipeline reveals that 56% are being developed by small businesses. By 2008, 95% of the medical device sector was SMEs.

While SMEs are at the heart of solving dry pipeline problems and creating jobs, all innovation requires funding. Venture capital and equity offerings (initial public offerings – IPOs) have been the traditional mainstays for start-ups. However, given the turbulent financial environment, this funding has virtually dried up, adversely affecting product development activities at most small businesses across North America and Europe.

Many countries have come up with stimulus packages to help SMEs pay off debts and take out new loans. But, as is the case with most stimulus packages, the aid is only for a short time, meaning a more comprehensive solution is needed to help with the growth of small businesses and reduce their dependencies on big medical device players or private funding to finance their projects.

Promoting and supporting SMEs

As SMEs form the majority of medical device companies worldwide, they are also the biggest employers in the industry. Consequently, they have significant social as well as economic implications. This fact is slowly being recognised by governments and industry lobbies, and has led to the introduction of several initiatives to safeguard the interests of SMEs.

A system that rewards successful entrepreneurs has encouraged the growth of SMEs, which have thrived and fuelled industry growth in North America and Europe. Besides the value placed on ideas and innovation, the system also encourages a strong base of related industries, such as suppliers, designers, technologists, clinicians and attorneys, which has led to an ideal setting for new medical device businesses in these regions.

Medical device companies are typically technology intensive and require a large talent pool of trained personnel. Consequently, access to research centres, hospitals and universities is the single most important factor for the location of companies. At the same time, cutting-edge technology requires large amounts of funding to develop and ultimately commercialise.

"Local governments in Europe and North America recognise the economic importance of small and micro businesses."

The majority of medical device SMEs in the early stages of development require considerable financial assistance for product development, getting market approval and commercialisation. Governments' financial incentives, ease of access to public and private funding, and infrastructure available are vital components for setting up a medical device company. Lastly, the proximity to the market for the commercialised product also plays an important role in determining where the company is headquartered.

The SME sector plays an important and significant role in driving innovation in the industry. In the market conditions, medical equipment companies are increasingly looking towards SMEs for potential solutions to their dry pipeline problems.

A typical product is based on mechanical, electrical and/or materials engineering, where an average product lifecycle (and investment recovery) is around 18 months before an improved product becomes available. Also, it is relatively simple to introduce a me-too product into the market; so rapid innovation is required by companies to keep up. This inherent need for a faster product development cycle has made the industry even more dependent on start-ups, which have been a source of innovation in the past. Changing demographics and demand for increased cost efficiencies as well as an increase in healthcare expenditures around the world are also putting pressure on companies to come up with improved products faster.

An analysis of 3,988 products in the pipeline in the medical device sector reveals around 60% of these have been developed by SMEs. These statistics illustrate a considerable role of SMEs towards new product development.

Financing and government initiatives

The healthcare SME sector is particularly research intensive and requires regular investments at different stages of their development in order to grow. This investment comes from a variety of sources such as government grants, bank credit, venture capital firms, private equity, public markets (IPOs), and industry partnerships. The majority of these small and medium companies do not have a revenue-generating product in place to fund its research and development activities. Therefore, they need to look for alternate sources of funding for their projects. Depending upon its stage of development, different types of funding options are available to these SME companies.

The financing sources are not distributed equally at all stages of development. The availability of finance is largely dependent on the risk stage of SME. For instance, governments play a major role in facilitating the availability of finance for research and development, a high-risk stage for a small business.

Venture capitalists (VCs) are more risk averse, and enter the picture only at seed stage, wherein small businesses already have a lucrative business model to pitch. Private equity (PE) has recently entered the healthcare sector as one of the major financiers during the early growth and expansion stages of the company. IPOs are the major exit strategy for VCs and PEs, and also provide funding for business expansion. Partnerships with other companies are another important way through which SMEs gain finances for their operations and can leverage the expertise and infrastructure of bigger companies.

However, the economic downturn has resulted in the decline in some major sources of funding such as VCs and PEs as their own investment levels have declined. Meanwhile, stock market volatility has resulted in a lukewarm IPO market, meaning the stagnation of VC funds.

Local governments in Europe and North America recognise the economic importance of small and micro businesses, and have set up an extensive support system for their development. Government initiatives in these regions can be divided into hard and soft initiatives. Hard initiatives provide monetary support to small businesses in the form of direct access to loans as well as facilitating funding through collaborators and intermediaries.

Through soft initiatives, the government aims to provide training to innovators in entrepreneurship, marketing advice and access to information. While the European Commission provides support to SMEs in Europe, independent bodies such as the Small Business Administration (SBA) run several programmes in the US. Canada has a Small Business Financing Program (SBFP) which provides access to loans via intermediaries.

The most comprehensive support for SMEs is provided by the US through the SBA, which was established in 1953. The SBA provides financing to SMEs in the US by guaranteeing loans through commercial lenders and intermediaries. It also facilitates VC funding for the small companies by providing access through its licensed investment companies under the Small Business Investment Company (SBIC) programme.

"VC firms invest in early-stage companies with high potential for future growth."

SBIC raises private capital and borrows funds from SBA at favourable rates, and in turn uses it to provide finance to SMEs. SBA also coordinates the activities of the Small Business Innovation Research (SBIR) programme. The SBIR programme is part of the Office of Technology and encourages SMEs to develop innovative technologies and commercialise them. Besides funding, the SBA also runs multiple training and management programmes, which provide guidance to small businesses through seminars, presentations and workshops.

SMEs and their role in the industry

VCs and PEs have, in the past, increased their investments in the medical device and biotech sector because of the perceived high potential of the Europe and North America healthcare sectors. VC firms invest in early-stage companies with high potential for future growth.

Similarly, PE firms invest in start-ups, and help them with streamlining their operations. Small businesses in healthcare are typically started by innovators who have little knowledge or experience of entrepreneurship.

VCs and PEs help these businesses by providing adequate management support. However, these firms invest with an intention of profitable exits from their investments. The biggest exit strategies for VC and PEs are public offerings or acquisitions by other bigger companies.

In 2008–09, mergers and acquisitions (M&As) were hardest hit by the economic downturn, leading companies to adopt or introduce policies of cash conservation. Despite the total numbers of M&As in the healthcare sector increasing for 2008, the value of deals reduced drastically. In 2008, there was not even a single IPO in the medical technology sector, while 16 companies withdrew their IPOs in the same year in the US.

Due to a lack of suitable exit strategies and consequent investment lock-ins in old deals, new PE and VC investments declined in 2008. According to National Venture Capital Association, the total value of VC funding declined by 13% in 2008 to $4.bn. For medical devices, VC/PE funding declined 26% in 2008, raising only $16.5bn.

At the stage when SMEs are growing, they need greater financial resources to continue investments in product development. IPOs are considered an important source to raise finance. IPOs can also act as an opportunity for VCs and PEs to exit their investments profitably. IPOs not only bring a fresh round of financing but can also enable VCs to exit their existing investments profitably, making finance available to other start-up SMEs.

The uncertainty in the stock markets has resulted in a lukewarm IPO market. Since most institutional investors have been reluctant to take risks and invest in new companies, IPOs of SMEs have been unable to generate sufficient funds in the past year. In the healthcare sector, the number of IPOs in 2008 declined by as much as 80% compared to the previous year. A similar trend in the IPO market is being observed in 2009. This has resulted in a credit crunch for growth stage companies, for which IPOs were a major source of finance.

However, the IPO market is expected to show signs of recovery by 2010, as the US economy slowly comes out of recession. The economic downturn and the high risk associated with early investments in SMEs has made angel investors and VCs less inclined to fund SMEs at the early stages of product development.

These investors are increasingly investing in low-risk, late product development. Growth-stage companies have also been hit by the poor IPO market and the dearth of private funding has resulted in increasing competition for government funds.

Governments across Europe and in the US have pledged more funds to support small business innovation through inclusive stimulus packages and higher research grants. However, most of these grants are limited to the early development phase, and do not support firms for commercialisation during the growth phase.

These factors have created a gap in funding for the early and growth-stage development of SMEs. SMEs are considered to be high-tech and are confronted with three types of risks:

  • technological risk, due to the explorative nature of R&D and production of high-tech products
  • market risk, as a result of the high uncertainty in the high-tech product market
  • financial risk, since innovation requires huge upfront investment.
"Despite the total numbers of M&As in the healthcare sector increasing for 2008, the value of deals reduced drastically."

Governments in Europe and North America have useful instruments for the funding of SMEs. By expanding their reach to biotech and medical technology start-ups, early-stage financing problems can be solved. For instance, extending loan guarantees to banks for investing in SMEs for research is a positive step, since it would improve declining banking credit for high-risk stages, and reduce high-risk premiums charged by them.

Another method is to increase VC funding via co-investment, which would increase risk capital. Besides funding, the governments also need to provide better guidance and training for SMEs to help them run their operations.

Leading healthcare industry players are generally cash rich and have grown in the past year despite the economic downturn. They can therefore afford to invest in the R&D activities of smaller companies through licensing activities and partnerships. However, this investment usually comes when investment is a low-risk proposition.

These companies are now exploring the option of risk sharing using innovative investment models, and investing at early product development stages. The concept of risk sharing sets the value of an innovation conditional to demonstration of its effectiveness and efficiency in real life.

Early investments in smaller companies can help bring successful products to markets faster. Collaboration at the early stages also reduces the investment required by large companies and maximises the profit potential of their investments. Incentives from government can help attract more industry players to invest in early-stage companies.

A coordinated effort between the governments, and industry players, can ensure growth and sustenance of SMEs at all stages of development.