Should Venture Capital Invest in Digital Health?

tl;dr

• The average digital health startup has not demonstrated financial sustainability on venture capitalists’ typical ~10-year exit timeframes, as seen in data from a recent article by Bessemer Venture Partners. 

• In the new macroeconomic environment, it is increasingly difficult for unprofitable companies to raise the capital needed to sustain themselves, and for venture funds to achieve their desired financial exits within their traditional/expected timeframes.

• Success stories like Doximity and Hims & Hers exemplify that both healthcare SaaS and tech-enabled services businesses can generate attractive financial returns.

• But the cases of unprofitable digital health companies that were once held up as exemplars of industry success – like Health Catalyst, One Medical, and Livongo – have put a damper on the market.

• Advances in technology, such as automation and AI; healthcare regulation, including major legislation as well as ongoing actions from federal entities like CMS; and improved venture investment discipline should enable digital health companies to reach financial sustainability more quickly than in the past.

To Invest or Not To Invest (in Digital Health)

The primary goal of most investors is to generate the highest risk-adjusted returns. This might seem obvious, but I think it is worth stating since it is not always at the forefront of conversations about venture capital (VC) investing, at least in the digital health space. In plain English, optimizing for risk-adjusted returns means investing in companies that will generate large profits (“returns”) in the shortest possible amount of time, with a low likelihood of failure/not returning the initial investment (“risk”). Think about it this way: if you can get a 3.75% annualized return from your savings account or ~5% annualized return from 2 or 3 month U.S. Treasury bills, it’s a no-brainer to put the money in T-bills, which are highly liquid and widely viewed as the least risky investment in the world because they are backed by the U.S. government. 

Similarly, as an investor buying ownership (“equity”) in a startup, you want the company to become profitable sooner rather than later so that you can either take your share of the profits or sell your stake in the company for a higher price than when you bought into it. Since most VC funds have a 10-year lifespan – that is, the money that outside investors put into the fund is expected to be returned, with profits, within 10 years – VC investors are typically looking for companies that can return outsized returns within ~10 years. 

But recent data published by Bessemer Venture Partners suggests most digital health companies – those providing healthcare software (SaaS) or tech-enabled services – don’t reach profitability on that timeframe.¹ The data shows that the average digital health company generates free cash flow margins² near 0% (for tech-enabled services) or low single-digits (for healthcare SaaS) by the time they have hit $100M+ in annual recurring revenue (ARR). According to the article, reaching $100M+ in ARR takes a median of 10.2 years for healthcare SaaS businesses and 10.6 years for tech-enabled services businesses. 

The implication is that 10+ years in and at $100M+ ARR, the average digital health company is unprofitable or barely profitable.³ Many health startups are still burning cash by the time their VC backers are pushing for an exit.⁴

Granted, a company that is unprofitable might still be able to exit. This could happen through an acquisition like Amazon’s purchase of One Medical in 2022 or CVS’s announcement that it is buying Oak Street Health in 2023, or by the company going public, as many healthcare startups have done in recent years. One might invest in a company that is burning cash if it seems likely that the company can eventually generate cash flows – for example, by acquiring customers and scaling revenues to a point where the company has significant operating leverage (the ability to sell more products/services on the same fixed cost base, so that incremental revenue boosts profits) or economies of scale (costs decrease as sales increase, e.g., through greater purchasing power with suppliers). Health Catalyst, a data and analytics software company for health systems, went public via IPO in 2019 and quickly traded up from its $26 IPO share price to $38, even though the business had burned $40M cash on its $113M revenue in 2018.

But in today’s changed macroeconomic environment, in which investors can get ~5% risk-free returns on short-term T-bills, fewer investors want to take the risk of investing in companies that have not generated cash for 10+ years and are not guaranteed to do so in the future. Bill Evans at Rock Health Capital quantified the recent shift in investor sentiment even upstream of this, for growth stage digital health companies. When early investors do manage to exit an unprofitable company and make a profit on their initial investment, there is still a risk that the company will never become self-sustaining. This risk is borne by the company’s new owners, employees, customers, and patients (either as the company’s direct or indirect customers). In the case of Health Catalyst, although the company has substantially grown its revenues ($276M in 2022), it continues to burn cash. Its stock traded in the $11-$13 range in April 2023, significantly lower than the IPO price at which early investors were able to cash out, indicative of more sober expectations about the company’s future.

As current or future patients, it is in all of our best interests to foster innovative, self-sustaining businesses that improve U.S. healthcare. The Bessemer data raises important questions: Can digital health companies eventually generate healthy profits and sustain themselves? How long does this typically take? And what might increase the likelihood of companies succeeding in this?

Epic Wins

Despite the seeming barrage of news about floundering digital health companies these days, there are clear examples of companies, both in the healthcare SaaS and tech-enabled services spaces, that have become financially self-sustaining.⁵ 

One of the best known success stories in healthcare software is Epic Systems, the most widely used electronic health record (EHR) in the U.S. In 2021, Forbes reported that Epic had an EBITDA margin above 30% and served 39% of the market. But Epic wasn’t an overnight success: the company was founded in 1979 and the business took off nearly 30 years later, after the HITECH Act was passed in 2009. Epic’s revenue doubled from $500M in 2007 to $1B in 2011 and reached $3.8B in 2021. Epic was privately financed by its co-founders with minimal outside capital over the years, and the notoriously quirky CEO, Judith Faulkner, fell out with her co-founder over her insistence on avoiding external funding (he later publicly admitted that she was right). Had Epic been backed by VCs, waiting 30 years for the company to reach its current scale and profitability might not have seemed like a success relative to other available investment opportunities over that time period. But this kind of slow start is not unusual in digital health; investor Chrissy Farr recently made a similar point about Noom – having started 17 years ago, Noom isn’t the overnight success that people might assume.

Doximity is a newer healthcare SaaS company that has demonstrated remarkable financial results on a rapid timeline. Founded in 2010 as a “LinkedIn for medical professionals” that generated ad revenue from pharmaceutical companies, Doximity has since expanded to selling recruitment tools and telehealth solutions to health systems. According to Doximity’s 2022 10-K filing, it counted 80% of U.S. physicians and 90% of U.S. medical students as members. Just last week, a friend who is a medical student told me she relies on Doximity’s dialer app during clinical rotations to call her patients under the hospital’s caller ID – all because the clinic she works in doesn’t have enough desk phones. The company has made itself well-loved by clinicians who desperately need basic productivity tools to do their jobs. Doximity was already profitable when it went public in 2021; its public offering prospectus reported $207M revenue in the company’s 2021 fiscal year and a 31% adjusted EBITDA margin (26.5% GAAP EBITDA margin). Profitability has steadily increased and the core business continues to generate positive cash flows since going public: cash flow from operations was $127M in FY 2022, reflecting a 37% margin of revenue. In comparison, Meta, a much more established company in a technology sector renowned for its profitability over the last decade, had a 43% margin of cash flow from operations to revenue in 2022.⁶ It would be difficult to argue that Doximity has not demonstrated an appealing risk-adjusted return. 

On the tech-enabled services side, Hims & Hers has had a remarkably rapid ascent to financial sustainability. Similar to Ro, which is still private, Hims & Hers connects patients via telemedicine to healthcare providers who can prescribe medications for issues such as erectile dysfunction, hair loss, and acne; the company also fulfills prescriptions on a subscription basis. The company was founded in 2017, went public via SPAC in 2021 after reporting $149M in 2020 revenue, and achieved EBITDA profitability in Q4 2022, a year in which the company reported remarkable growth to $527M revenue. In its Q4 2022 earnings call, management attributed Hims and Hers’ profitability to achieving economies of scale and greater operating leverage.

These success stories are heartening, and Andreesen Horowitz recently published an article delving into some of the drivers of financial “magic” (e.g., leveraging network effects and partnerships as strategies to lower the cost of acquiring new customers, employing tactics to retain and even grow business with existing customers, etc.). However, the Bessemer data suggests these successes are not representative of the average digital health investment to date. 

Goodwill Hunting

The hype around digital health and the associated large amounts of venture funding that have gone towards the sector over the last decade have culminated in many disappointments, especially as more companies’ financial data has become available when they have gone public or been acquired.

As a former patient of One Medical and an admirer of the frictionless consumer experience it pioneered in primary care, I was intrigued to learn about the company’s financials when it went public in 2020. One Medical ended 2019 with $276M revenue, 39% gross margins, and $53M of net losses. Amazon announced that it was acquiring One Medical in 2022 and completed the $3.9B acquisition in early 2023, following a year in which One Medical reported over $1B in revenue – growth comprising organic expansion and its 2021 acquisition of the value-based care primary care company Iora Health – with much lower gross margins (18%) and mounting net losses (-$400M). While Amazon presumably had a strategic rationale for acquiring such an unprofitable business (and then slashing its annual membership price from ~$200 to $144), one might wonder how One Medical would have continued on with such hefty ongoing cash needs (the business burned $212M in 2022).

Livongo Health, a virtual diabetes management company combining remote monitoring with coaching for patients, was initially seen as a massive success when it went public as an unprofitable company in 2019 and was subsequently acquired by Teladoc for $18.5B in 2020 (a 58x multiple over the company’s $317M 12 month revenue ending Q3 2020). But by the end of 2022 Teladoc had reported $13.7B in goodwill impairment charges, or write downs on the acquisition’s value, citing lower-than-expected growth in Livongo’s business. 

While financial data is harder to come by in the private markets, anecdotally I have seen a number of companies that have raised astronomical amounts of venture-backed funding but don’t yet have a sustainable business model several years into their investors’ ticking ~10-year clock. This raises questions like “is VC the right funding model for every healthcare business?” (probably not, but other funding options for startups are relatively limited) and “has the VC industry as a whole irresponsibly invested in digital health companies that don’t have clear paths to financial sustainability?” (probably, but this has been true across virtually every asset class and as Christopher Leonard helpfully explains, the Fed’s zero interest rate policy, or ZIRP, is also heavily implicated here). And, unlike other asset classes, VC is fundamentally about investing in innovation and bringing to life moonshots that can meaningfully impact society, an undertaking that can mean taking especially significant risks. If we want to change healthcare for the better, a foundational step is creating the conditions for great ideas to turn into sustainable companies. 

Better, Faster, Stronger

Three key trends should make it easier for digital health companies to build lasting, profitable businesses on faster timeframes in the coming years.

The first is technological advancement. In 2021, Julie Yoo at Andreesen Horowitz wrote a piece called “The New Tech Stack for Virtual Care.” She argued that new virtual care startups could get to market faster and more cheaply by leveraging newly available off-the-shelf tools for essential functions such as care delivery (e.g., telemedicine platforms, at-home phlebotomy companies), back-office administration (e.g., credentialing, revenue cycle), and front-office tasks (e.g., patient scheduling, payments, engagement). Since then, such startups have continued to proliferate; the extent of growth in the space gave rise in 2022 to Elion, a start-up building a marketplace for digital health companies to sort through the many vendor options.

The digital health tech stack has come a long way over just the last five years. When I joined Cityblock Health – a startup delivering integrated primary care, behavioral health care, and social determinants of health care to chronically ill patients predominantly on Medicaid – it was 2018 and the company had recently closed its Series A funding round. Together with a phenomenal physician leader, I launched the Care Product team to build out functionality in our proprietary software, Commons, that would enable our care teams (doctors, nurses, community health workers) to most effectively and efficiently care for our members (patients). As part of this effort, Cityblock’s engineering team built integrations from Commons to health information exchanges and other data sources that could provide care teams with more comprehensive and real-time member health information. While this was time- and labor-intensive, today, companies like Health Gorilla and Particle Health provide APIs for digital health startups to more easily access such data. Luckily, for some of this work our team was able to leverage Redox, a health tech company that allowed us to more easily pull information from EHRs such as Epic into Commons. This enabled Cityblock’s care teams to view key information from our members’ medical records and provide more informed care and care coordination. Had the ecosystem’s tech stack been even more mature in 2018, companies like Cityblock might have been able to productize our care delivery services more quickly and efficiently.

Today, AI is enabling automation of functions that have historically been costly for healthcare companies. In my prior role at Mount Sinai Health System, I was responsible for launching a healthcare navigation product and building a team to facilitate employees’ (whose employers had contracted directly with the health system) access to care. Tactically, this involved standing up a contact center that grew to support tens of thousands of patients over two years. Working with product and engineering talent on the health system’s digital team, we were able to implement some basic technology features that improved efficiency and consumer experience, like allowing patients to self-schedule their appointments. But our team of care navigators had to handle many more tasks manually, like responding to patient messages sent to clinicians in Epic, speaking with health insurance company representatives to authorize certain medications and procedures that patients had been prescribed, uploading faxes to the EHR, and answering basic patient queries about things like parking. Not only was this work tedious and repetitive, but it was also expensive for the health system to pay for the needed labor. Today, breakthroughs in AI are being used to automate some of this work, like Epic using GPT-4 to help clinicians draft responses to patient messages, Tucuvi employing conversational AI to automate medical phone conversations, and many other companies automating prior authorizations, customer service, and call center employee training and quality monitoring. These types of tools can decrease the cost structures of digital health companies and help them get to profitability faster.

A second enabling trend is around healthcare regulation. We have already seen how the HITECH Act opened up a massive market opportunity for EHRs like Epic. This has also played out in the clinical diagnostic testing space, where inclusion of a new test in the standard of care guidelines, such as those set out by the U.S. Preventive Services Task Force (whose recommendations are required to be covered by insurance providers under the Affordable Care Act), can drive adoption and, consequently, financial success. Exact Sciences’ non-invasive colon cancer screening test, Cologuard, followed this path to generate >$1B in sales in 2021. 

Looking ahead, new regulation can create opportunities for companies to generate attractive returns by accelerating or forcing adoption. As discussed in my previous post on access to medical records, ongoing implementation of the 21st Century Cures Act is expected to foster business opportunities in the health data space. Other examples include recent transparency regulations requiring healthcare providers and payers to disclose their contracted rates with one another, an opportunity that startups like Turquoise Health are turning into growing businesses, and new reimbursement schema around remote patient monitoring, which a whole host of startups have started leveraging to deliver important care that previously was not reimbursed. 

Finally, while Bessemer’s data is informed by the firm’s long investment track record and presence in the healthcare space, newer VCs with less access to historical data may now be at the cusp of recognizing weak financial performance in the digital health sector. This could lead to a VC retrenchment from the space, which paradoxically could improve the average investment return profile as both founders and VCs come to exercise greater discipline in company creation and funding. While investors previously funded companies voraciously, an increasingly cautious approach going forward could lead to the emergence of more companies that are financially sustainable.

Startups that successfully ride the waves of these trends may be better equipped to reach profitability more quickly, generate competitive financial returns on VC timeframes, and ultimately build lasting, impactful businesses. The data shared by Bessemer came from the first wave of digital health innovation – the pioneering companies that forged their paths in a less mature digital health ecosystem. Healthcare remains a sector with unique structural constraints on innovation, such as tight regulation, incumbent dominance, and general organizational inertia towards innovation. That said, with new technological and regulatory tailwinds – and with investors being more cautious than they were in the heyday of ZIRP – the future of digital health may be more optimistic than ever. 

Special thanks to Ryan Batenchuk for reviewing this and providing feedback!

1. According to an April 2023 Health Tech Nerds webinar with one of the article’s authors, the dataset included 106 healthcare companies split approximately evenly between tech-enabled services and SaaS companies and ~75%/25% between private and public companies, respectively. For definitions of healthcare SaaS and tech-enabled services, check out this Bessemer article from 2022.

2. The free cash flow metric is the holy grail of profitability because it represents the cash a company can return to its owners (shareholders) in the form of dividends, share buybacks, or further investments into the company’s growth and future profit generation. As my business school Finance professor constantly reminded us, “Cash is king!”

3. The Bessemer article also includes data on the companies’ average gross margins and operating expenses, which suggests their cost structures are not sustainable at this scale.

4. An “exit” is a way for VCs to get cash back for their initial investment, like through an acquisition or an IPO. VCs want an exit so they can return profits to their LPs (Limited Partners, or the people who put up the money for the venture fund to invest in the first place). For an exit to be successful, VCs are looking for someone else – an acquirer or public or private investors – to be willing to pay a lot more for the company than the VC did when they initially invested in it.

5. The examples discussed in this post are predominantly public companies due to the ease of accessing their financial data

6. Cash flow from operations is considered here (vs. free cash flow, which subtracts out capex) for the sake of comparison, since Meta has made significant capex investments in recent years.