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Why it’s a good year for diagnostics startups

Venture capitalists have typically shied away from investing in diagnostics. That mentality has changed, and a GE Ventures executive explains why.

One of the fastest ways to send healthcare VCs running for their Teslas is to tell them that you have a clinical diagnostics startup to pitch. That’s sad because diagnostic tests can provide clarity about a patient’s health, and are a critical part of the healthcare system.

Given their importance to medicine, why have diagnostics been so loathed by VCs? And given that aversion, why have investments in clinical diagnostics quietly risen to a record level this year?

Venture capitalists’ avoidance of diagnostics is understandable: Historically, diagnostics startups were terrible investments. The startups were too capital intensive, too slow to commercialize, and produced middling returns. Venture capitalists are (mostly) rational, so it’s no surprise that investment in the sector tanked in the recession of 2009 and lagged through 2013, as seen in Figure 1 (with data from Pitchbook).

That has dramatically changed. More on why that is the case later. For now, let’s look at the chart below.

Figure 1 tracks investment activity—including debt and equity—in private diagnostics companies. Clinical diagnostics generally fall into two categories, in vitro diagnostics (IVDs) and laboratory-developed tests (LDTs), and the fortunes of these two have diverged over time.

IVD startups develop and sell proprietary kits or instruments for measuring biomarkers. These startups are like the hardware companies of healthcare, developing novel technology. While this approach has advantages, including a recurring revenue business model, it also faces challenges, including FDA regulation and distribution logistics. There have been a few winners among IVD startups (GeneWeave, Accelerate Diagnostics), but these have been outweighed by failures. So, the surge in funding seen in Figure 1 is not due to an improvement in the IVD ecosystem.

While IVD startups resemble IT hardware, LDT startups are more like software companies, developing clinical tests on instruments built by other companies. It’s great to let another company do the heavy lifting of hardware development, but LDT startups still face the Sisyphean struggle of reimbursement.

You’d think it’s just a matter of running a test, billing the patient and being paid for your services, but healthcare is never that simple. Insurers are a skeptical bunch, and unless they were convinced of the clinical utility and health economics for a new test, they refused to pay for a test. The cost of running a clinical lab combined with an inability to get paid turned the first generation of LDT startups into the investing equivalent of cash bonfires. Beautiful to behold, but unsustainable.

Of the dozen, well-funded, first-generation LDTs in Table 1, investors took losses on four that shuttered, while three have yet to exit after taking more than half a billion dollars from investors since 2003. The five companies in Table 1 that did exit by acquisition or IPO took an average of 10 years to provide an aggregate return of 2.6 times invested capital. Those lackluster results scared away a whole generation of venture capitalists.

But as we’ve seen in Figure 1, investment in diagnostics increased tenfold since 2009. If clinical diagnostics is a terrible investment, why is money pouring into the space? It’s not mass delusion, it’s NGS. LDT startups are heavily reliant on the instrument platform they choose, and many were wise to hitch their wagon to the rocket that is next generation DNA sequencing (NGS). [In the table above, Veracyte and CardioDx are GE Ventures portfolio companies.]

The well-documented, exponential improvement in NGS instruments, combined with growing clinical relevance of genomic data, led many startups to develop diagnostics based on the powerful NGS technology. These NGS-based LDT startups (NGS-LDTs) have offered happier returns for investors. Of a dozen, well-funded NGS-LTDs in Table 2, seven have exited, returning on average 4.4 times invested capital in seven years, and none has gone out of business.

The ability of NGS to decipher huge amounts of biological information quickly and cheaply is a primary factor in the improved return on investment for NGS-LDTs. For example, Verinata, Natera, and Ariosa sequence DNA from maternal blood and noninvasively assess fetal chromosomal abnormalities. This approach would not have worked as well with earlier, lower-throughput technology. The clear clinical benefit from the NGS approach helped Verinata et al. secure reimbursement from insurers, leading to rapid revenue growth and solid returns for investors.

Those lucrative returns explain investors’ renewed interest in diagnostics startups. Of course, the interest could sour. The FDA has tightly regulated the IVD industry but has traditionally provided little oversight for LDTs.

Increased FDA oversight could suppress investor appetite for the sector. It’s also possible that DNA sequencing is appropriate for only some clinical applications (cancer, prenatal) and diagnostics funding will fall again as investors realize that the NGS well is dry. Finally, it would be remiss not to mention that the spike in funding in 2014 was due to Theranos, which raised $810 million from 2005-2015 for its diagnostic platform before it spectacularly imploded. Another Theranos-like meltdown could remind VCs why they avoided diagnostics in the first place.

That said, the improvements in next generation sequencing show no signs of slowing, and returns from NGS-based startups remain strong. With those tailwinds, clinical diagnostics continues to attract robust venture capital. It’s exciting to see so much investor enthusiasm for this sector of healthcare, spurred by the impact of NGS in the clinic.

Photo: jxfzsy, Getty Images

 

 

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