E304 entreprenurship vignniettes (2)

CASE: E-304

DATE: 11/28/07

Sean Harrington prepared this case under the supervision of Lecturer Rob Chess and Professor Peter Reiss as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. This case was made possible through the generous support of The Ciesinski Family Fund. Copyright © 2007 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: [email protected] or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. 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 Stanford Graduate School of Business.

EARLY-STAGE BUSINESS VIGNETTES

In the spring of 2007, four budding companies were in the very early phase of their development. These entrepreneurial ventures illustrate the variety and breadth of new business ideas that can be pursued, and the unique issues that need to be tackled in order to turn each concept into a sustainable, profitable business.

COMPANY 1: RATIONAL FOOTWEAR

Rational Footwear was poised to address the unmet needs of millions of Americans who suffered from knee osteoarthritis. This slowly progressing but painful disease affected roughly 24 million Americans, of which only 5.6 million had been diagnosed. The founders planned to design, market and wholesale comfortable shoes with therapeutic benefits, leveraging clinically proven technology designed in Stanford University’s Biomotion Lab. The shoes would not only benefit those currently suffering from knee osteoarthritis, but would also help delay onset of symptoms for the 60 million Americans who were predisposed to the condition.

The Product

Rational’s first line of footwear would rely on Variable Stiffness Sole (VSS), proprietary technology designed by Professor Samuel Balmer, for its therapeutic and preventative benefits. The VSS system modified a person’s gait, causing him/her to walk with increased pronation—the rolling of the foot from the outside inward as it strikes the ground. This gait modification was caused by a variability of stiffness in the mid-sole of the shoe, with the inside portion of the shoe being relatively softer than the outside. This variation reduced the peak load on the knee at the time of foot impact, a key trigger of knee osteoarthritis. The VSS system was in the midst of being tested in clinical trials, but results from the six-month check-in were very positive. Patients in the study reported statistically significant pain reduction compared to the control group, and early results also showed a reduction in peak loads on the knee as a result of the new technology. Based on these early results, Balmer estimated that 90 percent of Rational Footwear

Early-Stage Business Vignettes E-304

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customers already suffering from knee osteoarthritis would experience noticeable pain relief after wearing the shoes for six months. Additionally, Balmer believed that Rational would help delay the onset of pain by five to seven years for those customers predisposed to knee osteoarthritis. The plan was to use the variable stiffness soles in a variety of classic styles of footwear, including casual shoes, athletic shoes, and sandals. Rational’s initial line would consist of roughly a dozen models and the outward appearance of each would not be impacted by the VSS technology used in the soles. The shoes would be designed to help people through regular, everyday use. As such, the footwear line needed to be somewhat fashionable. The founders estimated it would take approximately 8 to 10 months and $350,000 to develop and produce their first batch of shoes. Although Stanford University owned the rights to the VSS technology and had filed provisional patent applications, there was still some uncertainty surrounding the robustness and enforceability of this Intellectual Property (IP). Nike had been an early partner with Balmer as he developed the concept, and they worked with him to produce the initial 200 pairs used in the clinical trial. Soon after, however, Nike decided that the target market for the new shoes did not align well with their brand and they abandoned the partnership, releasing all rights to the technology back to Stanford. Additionally, given the relatively simple concept at the core of the VSS technology, no one was sure what would stop competitors from copying the design. Nevertheless, Rational was working on an exclusive licensing agreement with Stanford’s Office of Technology Licensing, and also planned to request a preliminary patentability investigation, which might help clarify matters.

Marketing and Competition

The primary target market for Rational’s initial line of footwear comprised those individuals suffering from knee osteoarthritis or those predisposed to it. The three main groups most commonly afflicted by the disease are: a) people over the age of 55; b) overweight individuals; and, c) people with a history of knee injuries. Given demographers’ projections that the number of Americans over the age of 65 would double from 2007 to 2030, combined with rapidly increasing levels of obesity, strong growth was expected in the target market. Spending for treatment of knee osteoarthritis in the U.S. was roughly $15 billion per year. Using a top-down approach, Rational estimated its total market opportunity to be $4.1 billion (see Exhibit 1). Rational expected its shoes would have a retail price of approximately $250 per pair and that the company would pursue multiple channels of distribution. The founders planned to market to physicians through peer-reviewed medical journals, conferences, and in-person visits—encouraging them to recommend Rational footwear to their patients. They expected a strong endorsement from doctors since there would be positive clinical data. They also planned to pursue an aggressive direct-to-consumer strategy, with targeted campaigns aimed to create a viral buzz around the product. There would also be a significant push into the retail channel, as they hoped to make deep inroads into “sit-and-fit”1 specialty shoe stores, which tended to attract 1 There are over 1,000 of these retail stores, consisting mainly of a few large chains, such as Foot Solutions. These stores offer a higher level of customized service and more of a focus on shoes that have therapeutic benefits.


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their target market. Finally, they aimed to market Rational Footwear to the 2,500-3,000 orthotists and prosthetists in the U.S., although they expected this channel to be least receptive, since they already dealt directly with alternative solutions such as knee braces. It was still unclear whether Rational’s line of products would be covered by any health insurance plans, but this was an issue that needed to be further investigated since it would have a significant impact on the choice of distribution channels. Depending on the strategy they selected, the cost to launch the product was expected to be between $500,000 and $10 million. In terms of competition, there were no other existing footwear solutions being sold commercially that directly aimed to treat knee osteoarthritis. Existing medical treatments for the affliction were either focused solely on pain reduction or were significantly more expensive than Rational’s offering. Over-the-counter and prescription pain medications, such as Advil or Celebrex, represented $5 billion in annual sales, but did nothing to inhibit progression of cartilage damage. Knee braces were effective at correcting alignment, but they were costly (as much as $500-$2,000) and patient compliance was quite low due to the unattractive and cumbersome nature of the device. Orthotics represented the most similar substitute product for Rational, but despite all the marketing claims, there was no medical evidence to prove they helped reduce pain. Knee replacement surgery was the most successful way to treat knee osteoarthritis, but it was considered a last resort by most people given the high price (approximately $30,000) and long recovery time. Finally, there were also a few academic institutions that had been pursuing research similar to that which had resulted in the VSS technology at Stanford. Notably, two researchers at the University of Virginia had developed a shoe design using carbon-fiber cantilevers that aimed to reduce knee pain from osteoarthritis, but it was yet untested.


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COMPANY 2: MINOVA

In 2007, gastric weight loss surgery was considered the most effective treatment for morbid obesity.2 This class of procedure, including gastric bypass and gastric banding, uses restriction as its primary mechanism, effectively shrinking the size of the patient’s stomach so that it fills more quickly and gives them a feeling of early satiation. Although efficacious, gastric bypass surgery had been classified as “severely dangerous” by the American Medical Association, and this led to the development of safer non-invasive obesity devices. It was expected that over the following three years, the first generation of such devices would come to market, having made it through the FDA approval process. Minova had a non-invasive obesity device that it believed had significant advantages over its first generation predecessors and was patentable.

The Product

The Minova device leveraged a proven mechanism for treating obesity—restriction—but unlike the other options available, it was non-invasive. Instead of using open or laparoscopic surgery, the Minova device was inserted into the stomach via the throat using standard endoscopic equipment and procedures. The device would latch onto the walls of the stomach, which the physician could then rotate in order to create the two separate pouches. The small and large pouches were then held in place using a clip (see Figure 1). A very early stage prototype of the device had been developed but no animal or human clinical studies had yet been conducted.

Figure 1: Minova procedure Compared with the first generation non-invasive devices that were expected to arrive on the market, the Minova device was significantly smaller3 and allowed for much shorter procedure times. It was believed that physicians could perform two to four times as many procedures in a given time frame using the device compared to first generation devices. It was also expected that

2 Anyone weighing 100 pounds more than their ideal weight is considered morbidly obese. 3 It was expected to have a 33 percent slimmer profile compared with first generation devices.


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patients would be able to leave the hospital on the same day as the procedure, unlike the then-current alternatives, which were all inpatient procedures requiring two- to four-day hospital stays.4 This had the potential of reducing the cost of the procedure to patients and insurance companies by approximately $10,000. Most importantly, the device was expected to be much safer than other non-invasive devices because of its size, which reduced the risk of perforating the esophagus, and its one-shot deployment, allowing the physician to complete the procedure without having to pass through the throat more than once. Like any other medical device, Minova would need FDA approval before going to market, and company founders believed this would take approximately six years. The FDA required rigorous testing of any new device for safety and efficacy, first on animals, then on humans, which involved hundreds and sometimes thousands of patients. The good news was the IP was free from Stanford. The Minova team had filed provisional patents on the device, and they had hired an outside expert to lead their IP development efforts. The bad news was they still had to make it through the long and arduous FDA approval process, and the typical cost of bringing a device to market was approximately $50 to $70 million.

Marketing and Competition

Minova had two main target customer groups: physicians and patients. Although both constituencies had distinct needs, their interests were closely aligned. The most important priority for both was safety. Only two percent of the roughly 15 million Americans deemed to be morbidly obese had been treated with gastric bypass surgery in 2006, and this low penetration was largely attributed to the high morbidity and complication rates associated with the then-current procedure. Company founders believed that first generation non-invasive devices would significantly increase this penetration rate through improved safety performance. Even a modest increase to 5 percent penetration would translate into a $3 billion market for obesity devices used for weight loss procedures. The company’s strategy for marketing would revolve almost exclusively around the physicians, and would involve targeting the 1,500 bariatric surgeons and 500 gastroenterologists in the U.S. The plan was to use a direct sales force, which was the model employed by other medical device companies. Prior to FDA approval, the marketing campaign would be strictly regulated and limited to clinical trial publications, advisory board meetings, and conference abstracts. Although the founders did not expect to induce much demand through direct consumer promotion, they were aware that insurance reimbursement for the device was critical to their success. Fortunately, they felt confident their device would benefit from the inroads made by first generation non-invasive devices, and they intended to fight for approval and coverage by the major insurance companies. When examining the competitive landscape, Minova focused primarily on the first generation non-invasive restrictive devices that were expected to reach the market around 2010. The founders felt this new line of devices would eventually completely replace the gastric bypass surgeries. They were also aware that a new technology or competing second generation device could be in early development, which had the potential of making their device obsolete. 4 An inpatient is a patient whose care requires a stay in the hospital.


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Another competitor they watched closely was Allergan, a multi-billion dollar device and pharmaceutical company, which produced the LAP-BAND® device that had been gaining popularity among bariatric surgeons since its FDA approval in 2001. The LAP-BAND® was an inflatable silicone prosthetic device that was inserted around the top portion of the stomach using laparoscopic surgery in a procedure called adjustable gastric banding. Since LAP-BAND® was the device most similar to Minova, they used it as a benchmark for pricing and planned to charge a moderate premium over its $3,200 price tag. It was believed the premium was warranted since physicians and centers could perform more procedures per day using the Minova, thus increasing their revenue stream. Further, LAP-BAND® was minimally invasive, which again increased the risks for the patient, required a hospital stay, and left a small scar on the skin.


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COMPANY 3: APOLLO HEALTH

Many patients and physicians were dissatisfied with the delivery of primary care medical services in the U.S. Patients experienced long waits to see a doctor, little time with the physician when they finally did get an appointment, and poor and unreliable service. At the same time, providers were increasingly frustrated by long workdays, limited time with patients, and the many administrative hassles of running a small practice. Their discontent was exacerbated by the continuing stagnation and even reduction in incomes for primary care physicians compared with other sectors of the economy. Apollo Health aimed to create a new network of primary care offices that would address all of these problems. The Service The core idea of Apollo was that redesigned workflow processes, which leveraged information technology, could lower the administrative cost of delivering care while also improving the level of service and reliability of the patient experience. At the same time, consumers would be willing to pay extra for better access to physicians and improved quality of service. Apollo estimated that by decreasing the number of patients a physician must see per day by almost half, together with improved IT systems,5 they could reduce the number of support staff from an average of 4.7 full-time equivalents (FTEs) per physician to about two per physician (see Exhibit 2). After some preliminary research, Apollo decided that a service fee of $99 per year would be acceptable to most patients and yet generate sufficient revenue to cover reduced physician workloads. This annual service fee would supplement revenue generated by the usual and customary insurance and out-of-pocket payments made by patients based on visits and procedures. In return for the fee, Apollo would promise patients same-day appointments; longer, more personalized visits; e-mail and phone access to their physician; and an informative, self-service website. With this model, Apollo expected revenue per physician to be about 20 percent higher and administrative costs about 45 percent lower compared with traditional clinics. With fewer support staff, it was critical that Apollo clinics be extremely efficient with their employees’ time. They planned to do this in part through a unique blend of information systems and IT-based automation. For example, they offered a set of web-based tools that would allow streamlined patient registration, health data input, and prescription renewal information. Coupled with these technological improvements, Apollo also aimed to redesign administrative workflows to ensure more streamlined handling of tasks and processes. Marketing and Competition For primary care clinics, word-of-mouth and insurance directory listings were the main forms of marketing, and this was expected to be true for Apollo. Providing a superior experience, such

5 In typical primary care clinics, physicians would see 25 to 30 patients per day, which allowed approximately 15 minutes per visit. At Apollo clinics, physicians would see as few as 15 patients per day, allowing approximately 30 minutes per visit.


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that patients would refer the clinic to friends, would be a key marketing tool. In addition, Apollo also hoped to use thoughtful site selection and market positioning as a part of their strategy for building a loyal client base. Based on initial market analysis, it was believed that the top six target markets represented over $375 million in potential annual revenue (see Exhibit 3). They expected that a clinic would lose approximately $500,000 in the first year of operation, but would be profitable and running at full capacity by the end of the second year, with an estimated revenue of $1-2 million per year and a 20 percent contribution margin. Although Apollo would compete with traditional medical practices, there were also some new healthcare concepts emerging. Some boutique concierge models, such as MD VIP, offered patients constant on-demand access to a primary care physician for a premium of several thousand dollars per year. On the low end of the market, pharmacy-based retail offerings, such as Minute Clinic, provided a new category of high-speed, low-touch clinics with a limited menu of services.


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COMPANY 4: FUEL-X

As the threat of global warming became more universally acknowledged by mainstream media, the price of oil rose above $80 per barrel, and concern about dependence on foreign petroleum sources increased, many entrepreneurs and corporations turned their energy and attention to developing alternative fuel sources. Biofuels, such as ethanol and biodiesel, were considered promising new sources of fuel for transportation, but their production was still fraught with inefficiencies and barriers to large-scale adoption. Given its chemical characteristics, ethanol was difficult to transport using traditional pipelines and could only be used as a minor component of fuel in most vehicle engines, while biodiesel was still very expensive to manufacture. Additionally, many chemicals, such as acrylic acid and succinic acid, were petroleum-based and production costs had risen steadily with the price of oil. Fuel-X had licensed technology from a university to engineer and optimize the organisms used to produce biofuels and bio-processed chemicals in a far more rapid process than other alternatives, which they believed would greatly improve the efficiency and cost of production. The Product Fuel-X was founded around a proprietary technology called Helix. This technique used genetic modification to create new strains of microorganisms that were optimized for performance in the fermentation process used to produce biofuels and bio-processed chemicals. Biofuel is a liquid or gas fuel that is derived from biomass,6 such as corn, sugar, manure, or crop residues. Biomass is converted into biofuel in a process known as biorefining, and this was usually done by adding microorganisms like Escherichia coli7 (E. coli) or yeast to the broken- down material so their sugars could be fermented. However, this process was very inefficient because the microorganisms were not naturally well-adapted to survive in such environments. For example, in the production of butanol,8 the current best strains of E. coli could only survive up to a 1 to 2 percent concentration level. This implied that the resulting fermentation broth was mostly water (98 percent), and in order to convert this broth to pure butanol, an energy-intensive distillation process was required. Using Helix, Fuel-X believed they could cultivate new strains of E. coli that would produce a broth containing significantly more butanol. The Helix technology had been developed over the course of five years and it had been shown to enable the identification of genes linked to traits in the microbes, such as productivity, tolerance to toxicity, byproduct creation, and the modification of these genes could be done 1,000 to 5,000 times faster using Helix compare to any other existing technique. They were able to simultaneously test thousands of individual gene modifications to determine which of them would have a significant impact on performance in biorefining. Once the most influential genes were identified, they could then be modified appropriately to produce a new optimized strain of

6 Biomass is material derived from recently living organisms, including plants, animals and their by-products. 7 E. coli is a bacterium commonly found in the lower intestines of mammals. 8 Butanol is a biofuel that was gaining attention because it could be used as a direct substitute for gasoline. Unlike other biofuels that typically required modifications to the engine or needed to be combined with gasoline, butanol could be run straight in a standard gas engine. It was not being widely produced because of efficiency limitations.


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the organism. This allowed discovery of new optimization paths far more quickly than conventional techniques. One of the company founders liked to use the analogy of testing a race car when describing the process. “To test a race car, you would normally need to make individual adjustments, such as changing the angle of the hood, and then do a lap in between each change to see if the car runs faster. Instead, we’re able to make a thousand changes to the car and only do one lap in order to find out which of the changes were effective in making the car go faster.” Patents had been filed to help protect the IP, but it was still unclear whether this would stop others from developing similar approaches. The main benefits that Fuel-X expected to provide were increased efficiency, reduced costs, and faster throughput times for production of biofuels and bio-processed chemicals. In the butanol example, by increasing the concentration of the broth to 3 to 5 percent, they would significantly reduce the distillation cost and quantity of input biomass required for production. Based on their scientific research and testing, founders were confident their technology could help boost production efficiency by 2-5 times, which would result in about a 50 percent reduction of variable costs. They also predicted that production plants could be reduced in size by 40 percent and throughput times could be cut in half. Typically, developing a bio-based process for a new chemical took approximately 10 years and $30 million, though the company believed they could shorten the time and financial investment with their technology. Marketing and Competition Although Fuel-X’s Helix technology had the potential to greatly improve the efficiency and cost-effectiveness of producing biofuels, it was still unknown what business model would best capture the value they were creating. There was a whole set of potential applications for the technology and a number of different markets that could be targeted. One option being considered was a pure licensing model, whereby Fuel-X would charge anyone interested in using the technology a fee for usage over a given time frame. Another option was to use Helix to produce a whole line of biofuels and bio-processed chemicals, which Fuel-X would then sell through distribution channels. To increase specialization of the company and reduce capital requirements, it might be more effective to focus on just one or two markets, such as acrylic acid or butanol production. In considering its options, Fuel-X looked at existing market sizes and weighed them against the risks associated with each and the potential penetration that could be achieved. The company estimated the motor gasoline market in the U.S. to be roughly $280 billion in annual sales, but it was still unclear how quickly biofuels would be adopted as an alternative and which types of fuels (diesel or gasoline or new blends) would be preferred in the future. Based on policy trends around the world, Fuel-X estimated that about 10 percent of fuel demand would be in the form of biofuel by 2010. In 2005, the U.S. was the largest producer of ethanol with 4.2 billion gallons of output, while Brazil produced nearly the same amount. However, when considering the ethanol market Fuel-X had to be cautious since their technology had not yet been tested on yeast—the primary organism used in the biorefining of ethanol. The other niche markets they considered, such as acrylic acid, each represented about $1 to $2 billion in U.S. revenue per year (see Exhibit 4 for market sizing.)


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Fuel-X’s technological approach was unique, but several other well-financed start-up companies were developing alternative approaches to optimizing the microbes that could be used for biofuels. A number of these were further along in development than Fuel-X, though due to secrecy it was difficult to determine the quality of the organisms they were developing compared to those that could be engineered using Fuel-X’s technology platform. Nearly all of the competitive approaches were based on discerning mechanisms found in nature and then improving upon them. Some of the competitive approaches had already attracted investments and partnerships from large energy and chemicals companies.


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Exhibit 1 Rational Footwear Market Opportunity

Exhibit 2 Apollo Administrative Staff per Physician


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Exhibit 3 Market Sizing for Apollo

Market Target PopulationMarket A 700,000Market B 330,000Market C 250,000Market D 130,000Market E 80,000Total 1,490,000

Exhibit 4 Market Sizing for Fuel-X

E304 entreprenurship vignniettes (2)

Education

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