Venture investors are pleased to see digital health companies continue to transform the healthcare system despite unprecedented challenges brought by the COVID-19 pandemic.

Funding for digital health startups broke records in the first half of 2020 as adoption of telemedicine and other remote programs spiked to meet the sudden surge in demand. But the future of digital health will be determined not just by consumers, technology developers and investors. Government agencies, insurers and public-market investors will also wield considerable influence, and investors are expecting more regulatory scrutiny from these stakeholders going forward.

This was a key takeaway from a July 30 virtual event held by Rock Health, “Unprecedented Funding in an Unprecedented Time,” where I joined Steve Kraus of Bessemer Venture Partners, Liz Rockett of Kaiser Permanente Ventures and Bill Evans of Rock Health for an in-depth discussion about the road ahead for digital health.

The digital health sector is facing its ultimate stress test as millions of consumers flock to digital health platforms, and as safety supplants convenience as the top selling point for these technologies. To pass this test, company founders and VCs must plan for the days ahead, when regulators, payers and public-market investors more closely scrutinize how digital health technologies are being used, from patient privacy and security to reimbursements.

Healthy Deal Flow in H1 2020

Investors and company founders are leaning in as the spread of COVID-19 presents new and unexpected opportunities across healthcare. And it’s not just venture firms that have stepped up their activity. The first half of 2020 saw corporate investors take a bullish approach despite the uncertainty and deep financial stress many healthcare organizations face this year.

Even with these considerable headwinds, corporate investors completed 76 transactions in H1 2020 (on pace to equal last year’s total of 143 transactions), according to Rock Health’s data. CVC investment surged in May with a spike of 28 transactions, which was 150% above the trailing 12-month average—beating the previous record of 26 transactions set in November 2017.

Liz Rockett said that Kaiser Permanente Ventures, like many corporate VCs, spent the early days of the pandemic tending to its current portfolio. But firms like KPV ramped up dealmaking as the need for digital health products grew quickly, and when company founders demonstrated they were ready to embrace the challenge, even if—for some—it involved pivoting their business models.

Steve Kraus pointed out that—after about a decade’s worth of groundwork being laid in the form of electronic health records and other digital infrastructure—the digital health sector has emerged as an important new pillar of the U.S. economy.

Digital health VCs have been extremely active in 2020. Later-stage companies are commanding large Series B and C rounds at high valuations. Early stage rounds still make up more than 50% of all financing deals, but it’s taking longer in 2020 than it has in the past for companies to close seed and Series A rounds as investors more proactively vet business models to minimize risk.

Beyond “Checking the Box” on Compliance

Regulatory compliance has always been a factor in the business plans of digital health startups. But this issue has moved front-and-center, as the increased adoption of telehealth and other programs means more handling of sensitive patient data. Complying with privacy and security requirements is not a matter of “checking the box,” but of painstaking planning.

Investors are doing extensive diligence on regulatory and other matters before they sign term sheets with early stage companies. They are also looking for more verification that a digital health startup’s business model will serve it well during the current pandemic and beyond, and that there is genuine product-market fit.

The caution is also reflected in the term sheets being signed. During the economic crisis that has come along with the pandemic, investors have begun structuring deal terms to limit risk.

Some venture capitalists are protecting their investments by securing veto powers for board members, strengthening operational controls and—in a few cases—instituting pay-to-play incentives to prod other investors to participate in current or future funding rounds. There’s also a greater push by investors to add independent board members—neutral industry leaders with deep experience—to help advise the company.

But don’t expect a return to the draconian deal terms we saw during the 2007 to 2008 stock market crash, when investors implemented full-ratchet anti-dilution preferences and other strict measures to limit risk. Both Steve Kraus and Liz Rockett pointed out that privately held companies are still somewhat disconnected from the up-and-down swings of the public markets.

The Road Ahead

Digital health startups are raising funding from a large and growing pool of investors. Later-stage companies are looking expectantly toward the public markets, while early stage startups seek to establish themselves in powerful new fullstack vertical solutions that are emerging.

VCs and corporate investors are moving the ball forward by actively funding new healthcare ventures, despite the many uncertainties in the global economy. They’re just exercising some caution.

Government agencies, health insurers, providers and other stakeholders will be taking a closer look at how new healthcare technologies—especially those that use patient data—are being employed. Investors want to make sure they are ready for this scrutiny.

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