3 Mistakes To Avoid When Forecasting The Market For Your Medical Device

By Scott Fishman, CEO of Envisage and Program Executive at The Wharton School

I both conduct and teach due diligence, and I see a lot of business plans from healthcare entrepreneurs. Among other things, I look for a cogent value proposition, an understanding of an unmet need, and a realistic calculation of the addressable market.  Anyone who is involved in this space sees a lot of business plans that surge and hit $100 million, or more, in the fifth year. However, the real market opportunity for a given new technology is almost never this proverbial dollar milestone (preceded by a “hockey stick” revenue surge), and I don’t know any solid investors who truly believe it is.  Rather, this is implicitly and mutually understood hyperbole, a biomarker of "investability.”

Projected sales for an early-stage technology are superficially quantitative, but like the breathless syndicated reports of billion-dollar markets and media pronouncements about new technology, they’re really a qualitative indicator: that the next big thing is … well, big.  I do some investing myself, and frankly, business pitches that start and end with tangentially supported big numbers leave me as cold as the ones that start by telling me about the exit rather than the technology or value proposition.  The numbers are usually in dollars, based on secondary research sources, and about as removed from real addressable market opportunity as a kid’s lemonade stand projecting sales based on the market for Snapple.

There are multiple problems with this kind of financial positioning, but I’ll focus on three key ones here:

1. True “hockey sticks” — products whose revenues suddenly head for the stratosphere after years of slogging in development and modest initial customer capture — are relatively rare, the result of a unique confluence of vision, technology, timing, unmet or unrecognized need, and yes, luck.   
2. Trend lines do not extend upward to infinity, and they are more often than not discontinuous in their upward (or downward) progression.  Every product or service offering that has ever been conceived, every industry that has emerged to replace another, will inevitably follow some variant of the product lifecycle “S-curve” you can find in any business textbook.
3. Addressable markets are measured in dollars only after they have been addressed.  They need to be projected on the basis of units, with those projections then translated into dollars on the basis of a wide and disparate range of market variables, most of them unique to the category.  So the typical business plan formula — “This is a $1 billion market says ABC consulting in its report Giant Healthcare Opportunities in Electromechanical Thingies – 2013, and we are so very conservatively going to capture 5% of that, so this is a $50 million opportunity” — is, to maintain the hockey metaphor, pure bullpuckey.

1. The Fallacy Of The Hockey Stick
It's clear why founders and investors want to buy into the hockey stick premise.  The juncture at which the revenue curve makes its abrupt upward transition is the inflection point for a dramatic increase in valuation.  In essence, it’s the ultimate proof of concept: Not only does the technology work, but people want to buy it.  The increase in valuation attendant on significant revenue confirms scalability and enables sale of the technology or company; but, it’s also useful prospectively because earlier stage investors want — no, make that need — to believe in the ability of the technology to achieve a hockey stick trajectory.

This, of course, generates a continuing quest for the needle-in-a-haystack development opportunity that is fully explicated, not more than a year or two from submission to FDA, and that targets a growing need among either a very large or very desperate patient population.   There’s nothing wrong with that; in fact, it makes perfect sense from an investment perspective to pursue the opportunity with already reduced development risk and a shorter timeframe to investment return.

So where’s the fallacy?   Well, hockey sticks have a long handle that turns abruptly upward into a steep angle. In a hockey stick graph, the number of customers acquired, units sold, or dollar revenues are plotted over time. In the early stages, valuation increases relatively slowly as the company establishes itself and its IP portfolio, builds collaborations with other companies, and creates a prototype for clinical development. The important part of the stick, from an investor’s point of view, is the inflection point at which the transition to an accelerating revenue stream takes place, because this is what encourages early stage investment.  Prospective deals need to look like they have the potential to become a hockey stick: That is, the company needs to achieve the point in the curve at which it can be sold or transferred at a significant premium to the amount already invested.  So the hockey stick projection, the probability of which ranges from hopeful optimism to outright fantasy, becomes the underlying argument for the investment’s worth.

Since the hockey stick is the product of vision, technology, timing, and presence of an unmet/unrecognized need, it represents for investors the confidence that this management team — with this technology, facing a particular set of market forces, and in the context of the current regulatory and reimbursement environment — can succeed where dozens or hundreds of other similar technologies have failed.  That confidence is both a contributor to and the result of magical thinking.  Having subscribed to the premise and the team, investors — usually savvy people who know better than to base their decision on emotion — suffer the same cognitive dissonance as everyone else.  Therefore, the universe to which they have subscribed also needs to look like a hockey stick, and thus validate their thinking.  If you are at the horse racing track, and you’ve put a lot of money down on Wow Baby, the reward circuitry in your brain wants ratification: the substantiation of a sharp upward spike in betting (corollary to the hockey stick spike on a prospective investment) on “sure thing” Wow Baby.  The possibility that Wow Baby may stumble and break his leg and/or the jockey’s neck at any time only lends flavor to the experience. 

2. Trend Lines Do Not Extend Upward To Infinity
If I sell $100,000 of product this year, it’s not such a stretch (conceptually or actually) to sell $200,000 next year, a 100% increase. Or even to get that number to $500,000 in the next year, a 150% increase from year two to three.  This, of course, is what the graph always looks like, veering toward some indefinite point on the horizon beyond the vertical and horizontal axes.  This point, not incidentally, is conveniently beyond the timetable that really matters to early-stage investors, whose aim is less a sustainable commercial entity than a liquidity transaction.

But consider for a moment what these trend lines mean in real terms, and the unreality of most business plans that assume not only an aggressive upturn in the slope but continuous acceleration thereafter.  Let’s assume that the unicorn growth rate of 10 or 20 percent, accelerating suddenly and irreducibly to 1,000 percent or more, is somehow plausible.  The challenge of maintaining the growth rate becomes patently unrealistic, and it is inevitable that the trend line will soften.  If I’m selling, for example, $500 million, getting to $1 billion or $2 billion presents a rather different challenge than getting from $100,000 to $200,000. Customer acquisition and growth are not limitless; at some point the pool of available new customers and the budgets of existing customers reach their limits. 

The old riddle asks, “What walks on four legs in the morning, two at midday, and three in the evening?”  Every product ever created, every service ever launched, every company ever incorporated, and every industry ever conceived follows the same pattern as any living organism: creation, growth, maturity, and decline.  It's an S-curve, not a straight line.

3. Addressable Markets Are Measured In Dollars Only After They Have Been Addressed
This one really gets my goat, maybe because I’ve spent a career generating data and calculating opportunity based on addressable market size and prospective uptake.  The idea that a dollar estimate of sales to an existing market can somehow underpin a new product forecast is practically absurd — unless we are talking about the case of an undifferentiated product destined to be priced at the same level as competitors and sold to exactly the same target audience (which begs the question of “Why bother?”).  Every new product faces a different set of dynamics: features and benefits, competitive environment, regulatory conditions, reimbursement status, timing of introduction vs. stage of market maturity, distribution, pricing, market positioning, and so forth.  Some of these, like competitive environment and response, are determinants of performance.  Others, like pricing of the new product, impact both expected performance and the translation of that performance into dollars.

It may be convenient to say, for example, that infectious disease antimicrobial susceptibility tests (ASTs) represent 25% of a $16 million in vitro diagnostics market, growing at 3% per year, and let that form the basis for projecting sales of your new AST. You propose to capture 5% of the market but ignore pretty much everything that will determine your ability to achieve that 5%.

Rather, you need to start from the number of current opportunities to test, adjust that by the possibility of expansion or compression through technological change or demographics or health expenditure controls, adjust further by the perceived advantage of your new AST, mediate the result by your expected pricing, adjust for reimbursement, account for the controls a handful of major diagnostic providers exert on access to particular tests, modify by the amount of money you or a proposed strategic partner have for sales and marketing, which in turn affects rate and absolute limits to uptake.…  You get the idea.  Then, and only then, can you calculate the range of prospective revenue (in dollars, Euros, or whatever).

If you throw a dollar estimate at a room full of investors, without market research on unmet need and market acceptability, and you base your projections on a market share projection (invariably described as “conservative”) without a genuine analysis of potential, all the great technology in the world isn’t going to save you.  Members of your audience will be annoyed, incredulous, tuned out, or asleep — but what they won’t be is impressed by your business acumen.  And while it may not be entirely fair to your transformational invention, to one extent or another we all really do bet on the jockey, and not merely the horse.