DO NOT COPY FLEX TECHNOLOGY

Transcription

1 UVA-QA-0811 Feb. 18, 2014 After years of development, William Krause knew that 2014 was the year to go big or go home. His Flexible Herbert Screw, a medical device intended to support the healing of fractured collarbones (clavicles), was ready for launch, and he had accumulated the necessary cash $1 million by his reckoning needed to comfortably see him through the start-up phase. Although evidence in favor of the invasive device was still inconclusive, other key players were now entering the space with remarkably similar technologies. 1 Complicating Krause s decision was the current state of negotiations with BioDevice, a large producer of medical devices. BioDevice was offering Krause $3 million for the intellectual property rights to the Herbert Screw, both for the current product and (Krause believed) for other potential applications. To help him with his decision to sell or go it alone, Krause had hired a financial consulting firm to develop an assessment of the commercial value of the Herbert Screw patent. Disappointingly, its report assessed the value of the current product at only $530,539 (Exhibit 1). Obviously, if this figure was correct, it made little sense for Krause to launch the venture himself. On the other hand, this valuation was far less than what BioDevice thought the intellectual property was worth. Krause was not sure if this was because of different assumptions about the market for the new device or because of the other potential uses BioDevice saw for the intellectual property. Krause prepared to dig into the financial model to see what assumptions had led to such a low assessment. 1 L. A. Kashif Khan, Timothy J. Bradnock, Caroline Scott, C. Michael Robinson, Fractures of the Clavicle, Journal of Bone and Joint Surgery 91, no. 2 (February 1, 2009): This case was prepared by Travis Sorensen (MBA 14), Assistant Professor Yael Grushka-Cockayne, and Associate Professor Robert Carraway. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2014 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation.

2 Collarbone Fractures and Forms of Treatment -2- UVA-QA-0811 Collarbone fractures (Exhibit 2) accounted for 3% to 5% of adult fractures in the United States, making the clavicle one of the most commonly fractured bones in the body. 2 The Centers for Disease Control and Prevention reported a total of 102,000 cases in 2010, 3 with different rates associated with gender (men are twice as likely to break a collarbone as women) and age. Two main treatment forms existed: nonsurgical and surgical. Traditionally, doctors had preferred the nonsurgical method, in which the arm was immobilized using a sling or figureeight bandage, and the fracture was allowed to heal on its own. This approach, however, left the patient without the use of an arm for several weeks while the fracture healed. Furthermore, with this nonsurgical approach, there was evidence pointing to a higher chance of nonunion, in which the fracture failed to heal properly (i.e., failed to form a continuous bone). 4 Surgical techniques resulted in fewer cases of nonunion. Surgery involved implanting a plate, pin, or screw in or around the collarbone. 5 Of these, the plate was at times reported to be so uncomfortable that many patients underwent a second surgery to have it removed. 6 Pins and screws were smaller than plates but caused more irritation to the skin and could expose patients to infections. See Exhibit 3 for a comparison of these treatment methods and the scientific recommendations regarding their efficacy. Flex Technology Krause established Flex Technology in 1987 and served as its president and CEO. A former university professor and an experienced biomechanical engineer, Krause had almost forty years of experience in medical and orthopedic product development and was recognized as an expert on orthopedic instruments and implants. He had been awarded thirteen patents for his medical devices, and two had been licensed to companies for worldwide distribution. In 1996, Krause designed and patented a flexible shaft for intramedullary reaming, which used a coil to shape a fractured bone, facilitating healing. Based on this technology, over the past three years, he had developed the Flexible Herbert Screw (Exhibit 4) a screw that fixed the coil in place when shaping a small curved bone, such as the collarbone, while still allowing 2 Kyle J. Jeray, Acute Midshaft Clavicular Fracture, Journal of Bone and Joint Surgery 15, no. 4 (2007): ; Jonathan Cluett, M.D., All About Broken Bones, November 7, 2013, About.com, (accessed Jan. 14, 2014). 3 Khan et al. 4 Clavicle Fracture, OrthoInfo, (accessed Jan. 14, 2014). 5 For a sample plate, see Locking Clavicle Plating System, Acumed, for a sample pin, see Rockwood Clavicle Pin, Biomet, products/platesscrews/rockwoodclaviclepin.cfm (both accessed Jun. 16, 2013). 6 Operating room time cost $29 per minute, and average clavicle surgery took 4.5 hours.

3 -3- UVA-QA-0811 flexibility. The result was a safe product that could be used to support the healing process of small curved bones. The screw was minimally invasive and did not require a large incision for implantation. It could be left in the body after recovery without any ill effects to the patient and thus required only one operation. Krause believed his screw had the potential to solve many of the problems faced by other inner-bone devices. The Valuation Krause first focused on the consulting firm s estimate of overall market size. Its 85,000 figure seemed about right, although Krause believed prudence would suggest it could be anywhere between 75,000 and 95,000. Krause also assumed that the market could be expected to grow at about the same rate as the U.S. population (2%), but he believed this could vary, perhaps in a normally distributed way, with standard deviation of 0.5%. Nearly every surgeon with whom Krause had spoken had been extremely enthusiastic about the Flexible Herbert Screw, but Krause nevertheless expected early sales to be difficult and agreed with the estimated initial market share in 2014 of 1%, although he believed it could be as high as 1.5%. He had to admit that there was some chance it would fail to get off the ground and thus earn a negligible market share. Subsequent market share growth was tricky; he could not argue with the consultant s base figure of 50% annual growth, but he was optimistic that it might be much higher and could even double each year. Still, Krause had to be realistic: there was some chance it would not catch on at all (advisers had continued to strongly encourage him not to be overly optimistic), and not only would there be no growth, but whatever initial market share he achieved might actually shrink. Krause decided to be conservative and acknowledge that, if indeed the product failed to achieve traction, the initial market share would shrink by half each year. If the product took off, Krause could conceive of achieving a dominant market share, but he had difficulty believing he would ever be able to capture more than half of the market. In 2023, his patent would expire, and Krause agreed that it was probably wise to ignore any residual value of the product at that point. Krause had carefully chosen the sales price of $1,000, and all marketing estimates were predicated on that price point. Sonoma Orthopedics had started selling the Sonoma CRx Clavicle Device in The Sonoma CRx was a nail that had a flexible section along the shaft and deployable fins. Sonoma Orthopedics had raised more than $30 million from investors, but its CRx device had not gained widespread market acceptance; it had sales of $2.9 million in Krause believed this was due in no small part to the device s hefty $7,000 price tag. Not only 7 (accessed Jan. 14, 2014). 8 Sonoma Orthopedic Products, Inc., Company Profile Hoovers, (accessed Jan. 14, 2014).

4 -4- UVA-QA-0811 was he confident that the Flexible Herbert Screw was a superior product (surgeons were often hesitant to use medical devices such as the CRx, with its many moving parts), but he also believed that price was a significant market driver, particularly with all the cost pressures coming to bear on the health care market in general and on medical devices in particular. Krause was determined to hold the line on the $1,000 price tag. This was eminently doable, he believed, because the relative simplicity of the device meant it could probably be manufactured for the $300 the consulting firm had included in its analysis, and perhaps for as little as $250. Krause recognized that unanticipated surprises in the manufacturing process, along with whatever modifications might be needed once the product actually reached the market, might increase manufacturing costs significantly, but he did not believe it would ever cost more than $500 to make the screw, leaving him with a comfortable profit margin. Because Flex Technology would be using independent distributors, Krause expected that selling, general, and administrative costs would contain both a fixed (internal) component and a variable (independent distributors) component. The fixed costs would be $400,000 per year, according to the analysis, with an additional $400,000 required in the first year for start-up activities. Krause agreed that the variable expense would likely be around the 30% the consultant projected, but he thought it could realistically be anywhere between 20% and 50%, depending on the difficulty of the selling process. So far, the consulting firm s estimates had seemed reasonable. But the final input, the discount rate, was a whopping 70%. The consultant told Krause that 70% was the standard discount rate the industry applied to start-up companies of this type, to account for the riskiness of any new venture. Krause found it difficult to believe that all start-ups could be given the same amount of risk. From what he recalled, the discount rate was supposed to represent the opportunity cost of investing in a start-up, and Krause certainly did not have alternatives that could earn him a 70% return. After speaking with some of his advisers, he wondered if he should not use a lower discount rate to value the venture, perhaps in the 30% range. Doing this immediately raised the value of his start-up to $3,938,499 (Exhibit 5), making the decision to move forward an easy one and a clear choice over the $3 million offer from BioDevice (or $2 million after taxes). Krause thought it seemed strange that the whole value of the venture rested on the discount rate, which supposedly accounted for risk. Certainly, if some of his assumptions turned out to be unrealistically high, the project could be a bust. Yet his conversations with BioDevice had led him to believe that its interest in purchasing the intellectual property rights behind the Flexible Herbert Screw was not a now-or-never proposition. If he tried to launch the screw himself and within the next two years failed to gain sufficient market traction, he firmly believed BioDevice would still be interested in purchasing the intellectual property and perhaps even taking over the Flexible Herbert Screw venture, under the assumption that it could utilize its distribution channels to significantly improve the product s performance. Would BioDevice still be willing to pay $3 million? Perhaps not, but BioDevice had made it clear that it was interested and would remain so in the near future (in part, Krause suspected, because it was skeptical that

5 -5- UVA-QA-0811 Krause would be able to make a successful go of it on his own). Krause thought it was reasonable to think that BioDevice would still be willing to pay $1.5 million in two years. All in all, Krause found it hard to believe that his venture was worth only a bit more than $500,000. But was it really worth almost $4 million? He could not help but wonder if he was missing something.

6 Source: Created by case writer. -6- UVA-QA-0811 Exhibit 1 Financial Consulting Firm s Analysis

7 -7- UVA-QA-0811 Exhibit 2 The Clavicle (or Collarbone) The clavicle, or collarbone, is a part of the shoulder that connects the ribcage to the arm. Data source: Posted to public domain under the Wikimedia Foundation by Pearson Scott Foresman, (accessed Feb. 18, 2014).

8 -8- UVA-QA-0811 Exhibit 3 Recommendations for Clavicle Fracture Care Type of Fracture/Technique Acute displaced diaphyseal (Edinburgh Type-2B) fracture Plate fixation Intramedullary fixation (nails) Nonunion after diaphyseal (Edinburgh Type-2) fracture Plate fixation with bone graft Intramedullary fixation with bone graft Grade of Recommendation* Acute lateral-end (Edinburgh Type-3B) fracture Coracoclavicular screw fixation C Plate fixation C *A = Good evidence (Level-I studies with consistent findings) for or against recommending intervention B = Fair evidence (Level-II or -III studies with consistent findings) for or against recommending intervention C = Poor-quality evidence (Level-IV or -V studies with consistent findings) for or against recommending intervention I = There is insufficient or conflicting evidence not allowing a recommendation for or against intervention Data source: Khan et al. C C B C

9 -9- UVA-QA-0811 Exhibit 4 Modified Herbert Screws Source: Photograph taken by case writer.

10 Source: Created by case writer UVA-QA-0811 Exhibit 5 Financial Consulting Firm s Analysis with 30% Discount Rate