Tis the season of the down round

There’s a long list of growth-stage companies in health-tech that could theoretically IPO if the markets were more friendly. Despite what you’ve been reading in the press, the IPO window is barely open right now for our industry. Even solid companies like Waystar I’m hearing took a valuation haircut with its debut this week, the first health-tech company to go public since 2022. The company said it will use the financing to pay off debt. Needless to say, I’ll be interested to watch what happens next over at Tempus, as it reportedly seeks a $6.1 billion valuation for its IPO.

Why is this such a problem?

Well as Luba Greenwood, a biotech investor friend put it to me recently, there should be three options on the table at any given time for a growth-stage company that needs money:

1. A fundraise via the private markets

2. An IPO (essentially a fundraise via the public markets)

3. M&A

The problem with our sector - and not Luba’s - is that option 2 is still an ‘avoid at all costs’ for most companies, at least until there are more signs that public market investors will be more receptive to these kinds of businesses.

What’s particularly tricky is that this digital health category is still emerging. Per banker friends, these companies are not traditional software businesses and do not compare favorably to them (selling to health care buyers is not the same as it is in most other sectors). These are still heavy services businesses for the most part. But the VCs who backed them are hoping they’re valued differently than traditional health care companies because of the technology aspect to what they do. That positioning is tricky, for reasons that we’ll discuss in this piece, and is still playing out.

Here’s what I’m hearing from bankers, analysts, media, investors and other important stakeholders about how this will all play out in the 2024/2025 timeframe. And where I’d be focusing my energies right now as a growth-stage digital health player.

In biotech, there’s a clear roadmap. Greenwood says that M&A activity is starting to heat back up, which is fundamentally a good thing because it allows private market investors to double down on the next set of new companies developing new molecules today. And the IPO market is also more active. So it’s feeling more healthy, and companies can simultaneously consider all three when they need to raise capital, taking the best option that materializes.

Digital health at the growth stages is still very reliant currently on option 1.

That’s because M&A (option 3) hasn’t heated up quite as much as investors had hoped. The big technology and retail companies are doing it a bit of it — the biggest examples that spring to mind here include Amazon’s purchase of One Medical for $3.9 billion, Amazon’s nearly $1 billion purchase of PillPack, and Best Buy’s $400 million acquisition of Current Health. These are all important deals that got people talking for a while, but they’ve been a lot less frequent than many VCs had hoped.

Making matters worse, we’re also not seeing much M&A interest from Payers, health systems and other more traditional health care players.

There’s been a lot of industry chatter in recent months about Teladoc’s $18.5 billion acquisition of Livongo being the exception, and not the rule. The question of the moment: Could something like that happen again or was it an aberration?

There’s also the potential for private equity buy-ups, and I’m sure these entities are circling around some of the growth-stage and publicly-traded digital health companies as we speak. But as I’ve written in this newsletter, private equity has also been slow, in part because of the lack of profitability and growing feelings of post-pandemic regret.

So that leaves option 1.

Let’s start by busting a myth. Venture capitalists do not operate totally distinctly from the public markets, as if they don’t exist, even if it might seem that way from the outside.

Particularly at the growth stages, these investors are looking for a strong justification that an exit in the form of an acquisition or an IPO will return their money several times over.

For the most part, these folks paid up in the pandemic, as hopes were riding high that virtual care would be the “new normal.” But they’re well aware now that it’s not going to be that easy, particularly as telemedicine seems to be a “tool in the toolbox” for most physicians versus any kind of wholesale replacement to the current system. As they look for “comps,” meaning the comparison set that they can use to incorporate into their own models and spreadsheets, there’s not a lot there to be excited about right now. Just look at how a company like Accolade (ACCD) is faring right now. Like it or not, Accolade is a comp for many growth-stage health-tech companies. Others to look at include Teladoc (TDOC) and Doximity (DOCS). The brilliant Blake Madden has been sharing some sobering data-points after analyzing the public markets. Interestingly, his outperformers include payments and revenue cycle management players like Change Healthcare and Waystar, as well as the consumer health company Hims.

Where that leads me is this: We are about to see a lot of downrounds in health-tech.

If companies can’t go public or sell, they’re left with few other options. Many of them raised at a very high price during the pandemic bubble, and now they’re in a very uncomfortable position. Burn is still high, they over-hired to justify all that cash, so they need the capital in the bank. And they need it yesterday, even despite all the RIFs we’ve been seeing.

Growth stage funds will react by offering them a lifeline - but with terms and conditions attached. Those terms will include things like term sheets that are not clean. That might include liquidation preferences where the later investors get paid out their money sometimes multiple times over before anyone else does. Companies will likely take it because there’s no other choice and they are holding onto hope of an IPO in the 2025-2027 timeframe.

To be fair, there are some exciting companies waiting in the wings that could change people’s perceptions of health-tech. Take Maven Clinic, for instance, which continues to fundraise and grow customers and revenue, as it expands out from pregnancy and postpartum and moves into more areas of women’s health. Kindbody, Omada, the MSK companies (Sword, Hinge) and some of the largest behavioral health companies (Lyra, Modern Health) are also strong contenders. The critical question here is how much the public markets would require these companies to be profitable, or could buy into a story of the size of the market and the opportunities for growth.

You won’t see any of this play out publicly, because companies have made it a point to avoid talking about their financials. Instead, it’ll be a conversation topic behind closed doors. The industry will know they’re happening, but won’t talk about it.

And there will be exceptions. Some lucky companies may have enough capital raised from the peak years to be able to ride out this period and make it to an IPO. Or they might even be profitable. Those companies are truly in a fortunate situation!

But for the rest, I predict it’s going to be a rocky period coming up. What I hope for is that there’s more of an open and honest dialog about how companies are working behind-the-scenes to protect their employees. In these situations, it’s often those people who are most impacted, at least financially. And it is utterly unfair, because they threw themselves into building these businesses for years, and they and their families deserve a favorable outcome.

How do we move beyond this?

Beyond the obvious - building profitable, sustainable businesses — where I think digital health companies should focus their efforts is also in communications. It’s critical that health-tech gets better at telling the story of why it exists, and why we all should care. What is the use-case outside of the pandemic? Why is this the future of healthcare? What opportunities exist to do well by doing good? We need to be talking about why health care doesn’t yet have its Plaid, or its equivalent of Salesforce. The rails are still being built, and we’re probably 10 to 15 years behind where fin-tech is today. For savvy investors with a long-term view, there’s real opportunity here.

The downrounds are coming. There’s not much we can do about that. But I do think health-tech companies can and should go on the offensive - so when the timing is right, the world understands their true value. Because right now, we’re straddling a weird and murky and unproven middle ground between health and technology, and there’s a whole lot of people out there who don’t get it.