Disruptive vs. Destructive Technology

Yesterday I had lunch with the CEO of a medical device start-up in Salt Lake City. He is playing in markets totaling over $30 billion, and if things go well, when he sells off to Abbott or Boston Scientific it will be the largest acquisition in Utah history (current record: Omniture to Adobe for $1.8 billion).

He introduced a concept based on Clayton Christensen's Innovator's Dilemma concept of disruptive technology shown roughly below:

For those not familiar with the concept, let me use computer processors and the figure above to illustrate (I apologize for the quality, I did it quickly in Paint).  Firms start entering in market 1 and VCs start investing capital.  The market hits it's apex around the time that other firms start entering in market 2 (disruptive technology) at which point less firms enter and less capital is invested in market 1 as the market becomes obsolete and the process repeats itself.  An important aspect is that the market starts over - zeros itself - during each disruptive cycle.

However, much of medical technology is different:

Let's look at cancer drugs for example.  The dependent variable here is the recurrence rate of cancer.  Entrant 1 produces a drug that has a recurrence rate of 80%.  Entrant 2 comes in with a better drug with a rate of 75% and so on and so forth.  But what happens when an entrant produces a drug that has recurrence rates of 4-2%?

At this point we have basically cured cancer and there are no more incentives to create new drugs.  The last entrant basically delivered a technology which destroyed the market.  Of course, entrants can always come in with cheaper drugs, but part of the problem is that VCs become uninterested in marginal improvements and aren't willing to finance expensive development processes (represented by the upward sloping line).  As capital markets dry up, fewer and fewer firms enter (represented by the downward sloping line).

One of the problems with the VC community is the way that VCs are compensated for their work - management fees.  As funds get used up, management fees decrease because they are based on percentages so VCs start raising new funds.  This means they pressure companies towards quicker exits.  To produce a quicker exit, firms cut corners and develop less effective technology.  The VC model shows many hash-marks on the percent reoccurance continuum because firms only have enough time and money to make incremental improvements compared to previous drugs.

Take away:  Because medical technology markets can be destroyed, firms can't hedge their risk by leveraging their technological capabilities into disruptive markets.  Instead of producing incremental benefits, firms should try invest in being the firm that destroys the market for all other firms; otherwise they will be destroyed and will have to find a new line of work.

By the way, according to my CEO friend, Clayton Christensen has already agreed to this.