Collapse of Innovative Spinal Technologies was Years In the Making, Sources Say; CEO Responds

2/3/09Follow @wroush

[Updated, see below.--WR] Our stories last week about the shutdown of Innovative Spinal Technologies, a Mansfield, MA, company that raised $75 million in private funding to market devices for stabilizing injured spines, prompted a number of IST’s former employees and business associates to contact Xconomy to help flesh out the details of the company’s demise more fully. A picture is now emerging of an organization hobbled by management decisions that distanced it from its founding scientists in Texas, impaired its ability to sell its products to surgeons and hospitals, and exhausted its capital too quickly before it could get traction with enough sales of its spinal devices.

In particular, several sources I interviewed blame the company’s failure on IST president and CEO Scott Schorer. He’s a 40-year-old serial entrepreneur, real estate developer, and former Army Ranger who joined IST in 2002 when it was spun off by the Texas Back Institute under the name MusculoSkeletal Research Corporation. It was Schorer who transformed the company from a research incubator into a standalone medical device manufacturer, and Schorer who single-handedly raised the company’s crucial $39 million Series B venture funding round in 2005, sources agree. But the same person ultimately “drove this plane into the ground,” says Stephen Hochschuler, a spine surgeon who co-founded the Texas Back Institute and was a member of IST’s board until 2006.

IST “would make a great Harvard Business School case study of what not to do at a startup,” Hochschuler says.

As we’ve already reported, IST used much of its venture money to relocate to facilities in Massachusetts and to hire more staff, eventually growing to more than 100 employees. But disappointing sales of the company’s pedicle-screw system—marketed as a minimally invasive way to fuse or stabilize spinal segments in patients with damaged intervertebral discs—evidently meant it couldn’t sustain itself at that size. It shed staff drastically in 2008, shrinking to no more than 10 employees before finally closing its doors on January 23.

Executives tried to avert a shutdown by selling the company, and were close to a deal with Biomet Spine, a subsidiary of Warsaw, IN-based Biomet, according to one source I spoke with last week. But Biomet backed off in the end, the source says.

And now, according to a confidential IST memo shared by one source, IST is requiring customers to return all implants and surgical equipment to the company.* The memo from IST vice president of quality assurance Brian Callahan, issued January 23 (the day the company closed down), says all IST customers must immediately send back their inventory while the company works through “strategic and financial issues” and seeks a “different corporate partner” to sell the technology. Because the equipment is no longer supported by the company, the memo continues, anybody who uses it could be liable for civil and criminal penalties. It’s not known how many of IST’s devices were implanted in patients. [*Updated, 8:00 pm, 2/3/09: The first two sentences of this paragraph were edited for clarification.]

I reached Schorer by phone today, asking him about the state of affairs at IST and soliciting his responses to the criticisms lodged by former employees and associates. Contrary to an assertion from one source quoted in my January 27 story, the company has not filed for bankruptcy protection, Schorer says. “We hope to avoid that,” he says. “Obviously we’re trying to sell assets in order to take care of our liabilities and obligations to all of our constituents—the creditors, the shareholders, and the employees.”

Schorer said that as long as these negotiations were going on, he will not be able to respond in detail to questions or criticisms about the path the company has taken. “I’m happy when we are done with the process to come back and talk about what happened,” he says. “I just don’t want that to interfere with the process or cause issues for the process.”

“We have nothing to hide here,” Schorer continues. “I’m fine after we’re done with all of this for the truth to come out about what happened here, and shed a more credible and balanced light on what happened, as much as I can.”

If the criticisms of Schorer’s decisions were coming from a single source, it might be easy to write them off as the opinions of a disgruntled former employee. But a great many people seem to be disgruntled about IST’s fate. And the twists and turns in that story seem to merit further exploration, considering how much praise the company won for its early engineering efforts and how much money it eventually burned through before shutting down.

Hochschuler and other surgeons at the Texas Back Institute hatched MusculoSkeletal Research in 2002 with the idea of earning a financial return on the extensive research going on inside the institute. “Initially we kind of gave all our technology away through our non-profit research foundation,” Hochschuler says. “But after a while we said, ‘this is crazy—we have so many ideas, and we’re so connected in the spine world, why don’t we do something for-profit that would still help the community.’ ”

Hochschuler says Schorer, who had scored a big success by selling his previous company, a medical device shopping site called CentriMed, to Global Healthcare Exchange in 2000, approached TBI together with an associated named Fred Moll about investing in MusculoSkeletal Research. At that time, the organization was funded by investments from big medical-device companies such as GE Healthcare. Says Hochschuler, “I met with them and I liked them and I said, ‘We’re not taking any individual investments, but Scott, if you will become the CEO, I’ll let you guys invest.”

Schorer accepted the post, and the company was soon renamed Innovative Spinal Technologies. In 2003 the company raised a $6.2 million Series A funding round that included investments from device companies ANS, Orthofix, Synthes, and GE. But the company’s big break came two years later, when Schorer persuaded Boston and South San Francisco-based MPM Capital, New York-based Orbimed Advisors, and Panorama Capital (a part of JP Morgan) to put up the $39 million Series B round.

In a 2006 profile of the company, Robin Young, a financial analyst who publishes Orthopedics This Week, called that “one of the largest amounts of capital ever raised by a start-up spinal implant company” and said IST “may well be the first surgeon-originated firm that was spun off to professional management and a who’s who list of private equity firms.” Young called IST’s pedicle screw product “very different from anyone else’s product” and said “we are impressed with this company…we can see JP Morgan/MPM/Orbimed’s money working very hard.”

But IST’s troubles seem to have started just after it raised the Series B round. One source I spoke with—an early employee at IST—said Schorer’s decision that year to move the company from its location adjacent to the Texas Back Institute in Plano to the Boston area was both expensive and ill-conceived. (Like several of the contacts I interviewed for this story and my January 27 story, this one is still working in the medical industry and therefore requested anonymity.)

Schorer’s reasons for the move, according to the source, were threefold: he wanted the company to be closer to the center of the medical-device industry; he was an outdoorsman type who didn’t like living in the sprawling Dallas-Fort Worth-Plano area; and he wanted to hire a veteran medical-device developer named Dennis Colleran as a vice president, but Colleran didn’t want to move to Texas.

Boston is obviously a hub for medical-device innovation, boasting companies like Boston Scientific and DePuy, an orthopedic division of Johnson & Johnson. But the spinal implants that IST was developing needed to be regularly tested, evaluated, and re-engineered by experienced spine surgeons—which the Texas Back Institute has in abundance. “You don’t move a company like this away from its pioneering group of surgeons,” says one source. “And the way the decision was disclosed to the founding surgeons was horribly handled. One surgeon found out in an elevator. The slap in the face, and the difficulty that came in repairing those relationships that were an absolute must for the product to be a success, was something we really never recovered from.”

Hochschuler confirms this part of story. “Scott comes in once he’s raised the $39 million and says, ‘Oh, by the way, we’re moving to Boston,’” he recounts. “It was like someone dropped an elephant on my desk. ‘It will be easier to hire engineers there,’ he said. I said ‘That makes some sense, but you’re losing the whole vision of why we [spun off IST] and how we did it.’”

Hochschuler resigned from IST’s board after Schorer’s decision, because, he says, “I just felt my input had no value.” And he says his fear about the move to Boston—that it would take the company too far away from the surgeons who could best test the spinal implants—came true. “What they had developed was outstanding—they were ahead of the curve” in the field of spinal stabilization, Hochschuler says. “Until they overengineered it, having lost the input they could have gotten if they had stayed here. So they were late to market, and rather than being a leader, everybody else caught up, and they became a me-too.”

I asked Schorer to respond to the assertions that IST’s relocation to Massachusetts had caused problems. He said he couldn’t comment.

Schorer’s second big mistake, in the view of Hochschuler and the two former IST employees I’ve interviewed, was deciding to build a direct sales force to market the company’s spinal implants and surgical equipment, rather than hiring an outside distributor with experience and connections in the medical device business. “We knew that that was going to be far more expensive” than hiring out the work, says the early employee who spoke with me. But the company didn’t know just how hard it would be to get its product into hospitals that had longstanding contracts with other medical-device suppliers. “The barriers to entry were far more difficult than anyone could have expected,” this source said. At no time did the company’s sales staff manage to book more than $100,000 per month in implant or equipment sales, the source says: “It was an abysmal failure.”

Hochschuler agrees that it was a mistake for IST to try to circumvent the established networks of medical-device distributors, many of whom already have longtime relationships with orthopedic surgeons. “In direct marketing, you have full-time employees who cost millions of dollars, and even if they’re not getting any sales, they’re getting a guaranteed salary, so what is their motivation to sell the product?” Hochschuler says. “But if you have a distribution network that only makes a percentage, then you’re not risking anything, and if you are smart about choosing them, they have other things in their bags that are already needed in the OR, and they don’t have to convince surgeons to let them in the door.”

When the company finally gave up on its in-house sales force around 2007, according to another source, it took a year to ramp up distribution through an outside firm. The shift was “significantly mismanaged,” the source says. “Our sales were mostly stagnant throughout that period.”

Asked to respond to these criticisms, Schorer again said he couldn’t offer a detailed response at this time. The decision to create an in-house sales staff “was approved by the board,” he says. “The risks were known. That’s an age-old debate. Everybody can take it either way.”

In the view of several of the former insiders and outside spectators I interviewed, IST’s last big error—one many startups have made, of course—was raising more money than it really needed. The company got too big, too fast, these sources say, spending more than it should have on items like the 38,000-square-foot office it renovated in a Mansfield industrial park. “I think we should have stayed at about 15 to 20 people in a very low-rent place until we had sales to support the kinds of initiatives that we wanted to do,” says the early employee. “That would have helped our chances. Instead, we moved into a very spacious, state-of-the-art facility—a space most companies would flat-out kill for—with no revenue.”

“It was an unbelievable opportunity, but it was overfunded,” Hochschuler agrees. “I think there was too much money and it wasn’t watched closely enough.”

It’s possible, the early-employee source points out, that Schorer was under pressure from the company’s investors to get big fast. “You have to understand that Scott was taking his directions from the board, and that they wanted their money back in four years,” says the source. “But this was not, based on the technologies I’ve seen, a four-year plan. It was more like a six-or-seven year plan.”

I’ve contacted MPM Capital and Orbimed Advisors to request their own views on IST’s shutdown, but neither firm has responded. For his part, Schorer says questions about the company’s expansion and its burn rate are things “we can talk about later, in the future. Every decision was made carefully and run by the board, with the intent to produce a good result.”

It will evidently take some time for all of the factors that brought IST to its current crisis to surface. Meanwhile, though, creditors are waiting to be paid right now. One source I spoke with at a medical-device company said that even before the shutdown, IST was months overdue on royalty payments for a device technology it had licensed.

As Schorer acknowledges, IST is attempting to raise the money to meet its obligations by selling assets. “The company hasn’t failed yet,” he says. “There are still some great products that we’ve innovated and that we expect will be on the market.”

But it’s all a question of what price these products might fetch. “It is still very much a strong technology in the field,” says the early employee I spoke with. “Do I think that there is $75 million worth of value in it, so that we could all end up with a dollar-for-dollar return? Yes.”

Hochschuler, however, disagrees with that assessment. He cites the abundance of spinal technologies now on the market, the increasing difficulty of getting the FDA to approve (or Medicare to pay for) any new medical device, and, of course, the economic downturn.

“In my opinion they are never going to see that number,” he says. “Had Scott gotten to market when he should have, this would all have been history. It would have been an ongoing, viable company. But now the perfect storm has hit, and nobody is investing in anything.”

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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