ArthroCare's Magic Wand

ArthroCare believes its new approach to tissue removal represents a quantum leap forward in arthroscopy and can be used in other clinical markets. But dogged by a perception that it didn't know what it wanted to do--it talked about new opportunities before it could act on them--ArthroCare now has to convince investors that it can deliver on its promises.

ArthroCare believes its new approach to tissue removal represents a quantum leap forward in arthroscopy and can be used in other clinical markets. Now it has to convince investors that it can deliver on its promises.

by David Cassak

• Using RF energy, ArthroCare has developed a new approach to arthroscopy that cleanly and precisely removes soft tissue in a way that conventional arthroscopy devices can't.

• But more than just a better arthroscopy device, ArthroCare believes it has a platform technology that can be applied to a wide range of surgical specialties, including general surgery, urology, dermatology and plastic surgery, and urology.

• Now cautious about promising too much until it has secured intellectual property rights and regulatory approvals, ArthroCare has in the past been dogged by a perception that it didn't know what it wanted to do—a result of talking about new opportunities before it could act on them.

• ArthroCare's rocky stock price history suggests that small companies that plan boldly and slip pay for it. The company's challenge: to find and exploit only the most promising of new opportunities.

This past October, Miami Dolphins' wide receiver Brett Perriman suffered a serious knee injury,the result of months, if not years, of hard hits and quick turns, that required mid-season surgery. But rather than being out for much of the rest of the season, Perriman was playing again in two weeks, virtually pain-free.

Okay, it was against the Chicago Bears. Still, the comeback was remarkable. And credit goes not just to the Dolphins' team orthopedic surgeon John Uribe, but also to a new arthroscopy system that Uribe uses which removes damaged tissue cleanly, quickly, and precisely, without the kind of collateral pain and unwanted tissue damage that normally accompanies arthroscopy.

The device was developed by Sunnyvale, CA-based ArthroCare Corp. , which itself has been notable for its comebacks. Begun as a cardiovascular device company, ArthroCare segued into orthopedics when early investors balked at the small market size of its cardiovascular product niche and a difficult regulatory process.

More recently, the company, which went public early in 1996, saw its stock price tank when it missed some early revenue goals. And it may have disappointed some investors and given the impression that it is still somewhat without direction by talking about new opportunities without actually being able to exploit them.

ArthroCare has rebounded recently: its stock is back nearly to its IPO price and its success in arthroscopy has been impressive. In addition, it has recently hired a new CEO and secured key patents to shore up a critical intellectual property portfolio. Most importantly, ArthroCare is ready to take its innovative technology into other clinical specialties, which could blow the lid off of the opportunity it has pursued for the last several years.

Still, significant challenges await. As it nears product launch in a number of new clinical markets, the company must overcome a perception among some investors that it has failed to capitalize on opportunities and has therefore been somewhat directionless. To do that, it must carefully select and chart its commercialization strategy, while at the same time managing expectations.

A Shift From Cardiology to Orthopedics

ArthroCare was founded in 1992 as AngioCare Inc. to develop products dealing with total occlusions in coronary and peripheral arteries. Founder Hira Thapliyal had previously worked at Devices for Vascular Intervention Inc., now a division of Guidant Corp. , and Cardiovascular Imaging Systems Inc. , a unit of Boston Scientific Corp. Along with co-founder Phil Eggers, Thapliyal patented a device which would enable cardiologists to do angioplasty in completely occluded arteries by placing electrodes at the ends of both an angioplasty catheter and a guidewire, and passing current from the catheter tip to the guidewire, the device would warm the plaque (without ablating or dissolving it), softening it just enough to allow the balloon catheter to advance to the point where it could be dilated.

Thapliyal and Eggers got the patent, but soon realized that there was a better way to deliver energy. Using a single electrode on the tip of the catheter and guidewire, the current would short out when it confronted an occlusion. Instead, they tried a new design, incorporating a multi-electrode device with bi-polar grounding.

Today, that bi-polar, multi-electrode design lies at the heart of ArthroCare's arthroscopy device. Using radiofrequency (RF) energy, ArthroCare's patented wand removes tissue in joints cleanly and quickly through a process ArthroCare calls Coblation, a shortening of the phrase cold ablation. "There was no charring," says Thapliyal. "We were using RF, but it didn't have the typical effect you'd expect from RF."

It was somewhat by serendipity that Angiocare became ArthroCare. Early attempts to raise money for AngioCare were unsuccessful—though the device worked, venture capitalists worried that the market for total coronary occlusions was too small to sustain a business. A call from another former colleague, asking if the new device would work in tissues of the joint, coincided with a call from a venture capital firm, Paragon Ventures, looking to invest in an orthopedics company. ArthroCare was launched with a $1 million investment from Paragon, and an additional $800,000 from private investors.

The shift to orthopedics had two major benefits, says Thapliyal. First, the market is much larger: 50,000 total occluded artery procedures are done each year compared with 2 million arthroscopies. Perhaps just as important, the coronary artery device would have required PMA approval; as an arthroscopy device, it would be a 510K device.

The Commercial Challenge

Altogether, ArthroCare raised $12 million in private money in four financing rounds between May 1993 and October 1995 [See Deal].

This past July, ArthroCare brought on Michael Baker, who had extensive experience in both business development and general management at Medtronic—he most recently ran Medtronic Inc. 's coronary vascular (angioplasty) businesses—to be CEO as the culmination of what company officials saw as a three-stage strategy.

The company's first goal had been to establish the intellectual property rights around its unique bi-polar device. Hira Thapliyal notes ArthroCare has more than 10 patents, with 20 pending; the announcement in early December that ArthroCare had gotten final patents on its bipolar design andCoblation technology was an important milestone in ArthroCare's efforts to secure its intellectual property position.

The second part of the strategy focused on getting regulatory approval. The company has more than a dozen 510(k)s, not just in arthroscopy, but in a number of other clinical areas including general surgery, urology, and dental. But, says Thapliyal, the hardest part was turning the intellectual property and regulatory approvals into a commercially viable business. "We had the patents, the 510(k)s," he says, "The question was, who's actually going to make us successful?" In September of 1996, Thapliyal went to ArthroCare's board to talk about bringing on a new CEO.

The ArthroCare system works differently than most RF devices because it operates on the principle of bipolar grounding and uses multi-electrode heads to deliver the energy. Passing current through a saline solution or some other conductive fluid, each of the electrodes on the ArthroCare wand emits a rapid blast of RF current when it comes in contact with tissue or bone. (It will dissolve tissue, but not bone.) The saline solution quickly becomes filled with high energy particles, causing a thin layer of saline vapor to form over the tips of the electrodes. When that layer of highly charged vapor comes into contact with tissue, it causes the molecular bonds in the tissue to break apart. "The tissue actually just vanishes," says Mike Baker. "Unlike heat-driven energy [such as standard electro-surgical bovies] where you boil the intracellular fluid causing the cells to rupture, this is a cool ablation process in which the tissue breaks down into individual molecules before forming again as a light gas, thus converting directly from solid to gas."

In the process, there's none of the extreme thermal effects that come with heat-driven systems, enabling the ArthroCare device to make very clean, precise cuts into the tissue. That, say company officials, makes it a significant advance over traditional arthroscopy devices—both bovies and those instruments which use shaving and suction actions to trim meniscus, remove tendon, or perform any of a number of other procedures to remove soft tissue, usually in either the knee or shoulder. These devices can cause significant bleeding or leave sharp edges in the process of removing tissue. They can also cause unwanted damage, either to other tissue in the damaged joint or to other internal structures such as the vascular supply to the knee.

Some companies have in the past tried to market laser as a solution to the limits of mechanical instruments, but the heat generated by lasers caused problems of its own. With the ArthroCare device, says Baker, "You can go into an articular cartilage defect and clean up the edges or trim a meniscus, leaving nice, smooth surfaces with a device that doesn't get very hot. The tissue isn't charring and the preliminary long-term data suggests that you don't get the vascular damage that you do with other devices." In procedures such as revisions to ACL (anterior cruciate ligament) repair, where surgeons must expose the metal screws inserted in the initial procedure, ArthroCare's wand can cut right to the bone without affecting the screw.

And because it instantaneously coagulates bleeding tissue, ArthroCare's device allows for better visualization, making even complex procedures easier and significantly faster than traditional devices because the surgeon doesn't have to change instrumentation to coagulate or cope with a blurred field of vision. Says Alan Weinstein, ArthroCare's VP, sales and marketing, "We aren't teaching them a new procedure. This is arthroscopy, and they know how to do it. But we make it easier for them, consolidating a lot of functions into one device and solving problems such as visualization and access to make removal of tissue easier."

A Mature Market

ArthroCare claims that the combination of precision and cleanliness that comes with Coblationmakes joint repair a particularly good target for its technology—as noted, conventional arthroscopy techniques remove tissue but can result in bleeding and ragged tissue fragments. Patients benefit too, as the Dolphins' Brett Perriman discovered, because the device reduces unwanted tissue damage, and significantly reduces pain.

And it's fast: shoulder procedures that normally take an hour can be done in around 30 minutes. As a result, says Alan Weinstein, surgeons who try the device tend to get hooked. "There's usually a short learning curve, around five cases," he notes. "Then they start using it for 80-90% of their shoulder cases. I've known surgeons who have canceled surgery because they couldn't get access to the system that day."

Currently in about 20% of all hospitals in the US, ArthroCare's system has been used in over 100,000 procedures. The product's cost profile should also encourage adoption, if only by eliminating one major issue for hospitals: cost. Typical reimbursement for an arthroscopy procedure is between $3-6,000; each ArthroCare wand costs between $120-190. "This isn't one of those procedures where the disposable cost is a huge chunk of the reimbursement," says Mike Baker. "It's a good deal for doctors and a good deal for hospitals."

Arthroscopy was an opportune place for ArthroCare to start for another reason: one of the most mature device segments, it's seen relatively little technological innovation in recent years. The Dolphins' John Uribe, a leading sports medicine surgeon from Miami, is one of ArthroCare's endorsing surgeons; he calls the device, "the first real breakthrough in arthroscopy in 10 years." More modestly, another surgeon says it's "one of only three real innovations in the last several years."

Indeed, ArthroCare officials insist that the device's principle virtue isn't that it allows surgeons to do existing procedures better; it's that it allows them to do procedures on a wider range of patients, patients who in the past might not have had arthroscopy. They say that a series of papers soon to be published will provide the first proof that surgeons using ArthroCare's wand are doing ACL revisions and fixing articular cartilage defects and getting good long term results. That's an important step forward, says Baker: "In almost every single knee arthroscopy—and there are 1.4 million of them a year—there's an articular cartilage defect that could be repaired if you had a quick, easy, and safe way to do it."

In addition, the company recently announced the launch of a set of wands for small joints, including wrists, ankles, and elbows. "When you read about pro athletes coming back two or three weeks after knee surgery, a lot of that has to do with our device," Baker goes on. "There's a lot less bleeding, trauma, and collateral damage, and the surgery is much faster. I think the more doctors actually understand what this device does, the more they'll use it for things they've assumed they can't do arthroscopically."

In the process, says Alan Weinstein, "we've made a big transition. This isn't just seen as a tool in doing a procedure, it's now defines the procedure as an ArthroCare procedure." Still, the lack of innovation in arthroscopy suggests limits as well as opportunity; surgeon conservatism becomes a factor in an industry that has seen little real technological advance over time—many surgeons, on first seeing the product, resist simply because they've been doing arthroscopy for years using devices with which they're perfectly happy.

Thus, as with any new technology, getting surgeons to accept it took time. Weinstein notes that, at first, many surgeons "thought this was just another shaver." Once they understood it, he goes on, "the response was fantastic." Early adopters would show the device to colleagues, who quickly got on the bandwagon, he says. "There were even fights at some places because more than one surgeon wanted to use it at one time. That's why a lot of our accounts have more than one unit."

Arthroscopy Product Profile

SOURCE: Rodman & Renshaw

Beyond Competition

Weinstein notes that the company's initial marketing efforts targeted the top 500 surgeons in arthroscopy, "and many of them are using the system." Of the 18,000 orthopedic surgeons in the US, around 14,000 do arthroscopy and 40% of those consider arthroscopy a major part of their practice. Working largely through 35 independent distributors and selling agents, ArthroCare has some 250 sales reps currently calling on physicians.

ArthroCare's device was particularly prone to early resistance because company officials were reluctant to explain how the proprietary technology worked until their patents were approved. Says Mike Baker. "I spoke to one doctor who said, ‘I don't have any idea how this works. What I'm seeing doesn't make any sense.' He used it because he felt he could do things with the system that he couldn't with anything else. But we couldn't talk to him about the core technology and why he saw remarkable results because, from an intellectual property standpoint, we were in the process of getting protection for the device."

Even the company's regulatory approach prevented it from talking in-depth about the technology. "With a 510(k), we didn't really have to describe the molecular mechanism of action, we just had to describe reasonable predicates," says Baker. In fact, the company encouraged comparisons with conventional arthroscopy devices by using shavers and bovie instruments, as well as other RF devices, as predicates. As a result, he goes on, "I think a lot of surgeons simply assumed that it was a fancy bovie or some kind of smart arthrosurgical device."

With several key patents finally issued this past December, ArthroCare officials are now eager to explain why the device is so unique. Alan Weinstein notes that one major opportunity for the company will come in expanded use in knee surgery, as surgeons realize the benefits of the cooler ablation process. "About 40% of our revenues come from knees, but our penetration has been a lot lower than we'd have liked because we haven't really been able to tell surgeons how the device works because of the patent issues," he says. "We haven't talked about Coblationand why this device works so well in the knee. There have been surgeons using this for articular cartilage defect and meniscus repair for two years, but we haven't made it a focus of our selling effort. That's what we're going to do this year, and it should open the market for us when physicians really understand the technology."

ArthroCare officials contend that the kind of conventional selling approaches that they used at first—based on cost-effectiveness over competitors' products—were effective, but sold the technology short. "Early on, we spent some time talking to doctors about how you can use our system to replace other devices, such as bovies and cutters, and save some money," notes Mike Baker. "And, in fact, you probably do save a little money—maybe five or ten dollars a procedure." But, he goes on. "If you're a surgeon, that's not why you use this for a pro athlete who wants to play again in two weeks. You use it because quite simply, you can get results with it that you can't get anywhere else."

As if to emphasize their unique approach, ArthroCare officials insist they don't see traditional arthroscopy leaders, Smith & Nephew Dyonics Inc. and Stryker Corp. as competition. "The closest traditional device is a bovie [which uses heat to coagulate within the joint]," Baker goes on. "But you wouldn't use this to replace a bovie." (The market leaders like Dyonics and Stryker also sell a lot of products ArthroCare doesn't make, such as surgical anchors and visualization equipment—cameras, light sources, and scopes.)

ArthroCare makes similar claims about shavers—their wand can certainly do what traditional shavers do, and orthopedic surgeons will likely use fewer shavers as they adopt the ArthroCare device. But if all the surgeon wants to do is to shave soft tissue, he'll likely use a shaver. "Sure, we've taken some business away from the shaver and bovie sales," says Alan Weinstein. "We've allowed hospitals to buy fewer hand-held instruments in some cases by replacing different instruments with a single system. But from a competitive point of view, we've done more to open the market than take business away."

But there are a couple of smaller companies who have begun to develop products using RF to cut soft tissue, including UK-based Gyrus Medical Ltd., whose product is distributed in the US by Ethicon Inc. , a Johnson & Johnson operating company, as part of its Mitek Surgical Products Inc. surgical anchor product line.

In the US, ArthroCare's closest competitor is Mt. View, CA-based Oratec Interventions Inc. , which is headed by CEO Ken Anstey, who successfully ran Mitek prior to its sale to Ethicon. While Gyrus has bipolar application, Oratec's is monopolar—both are single electrode devices. In both cases, however, ArthroCare insists it has seen little real impact on company growth.Says Alan Weinstein, "If anything, [their entrance on the market] has increased our sales and penetration because they've helped to validate the use of RF energy." (Mike Baker concedes, however, that interest Oratec has stimulated in tissue shrinkage prompted ArthroCare to quickly develop a similar product just to have something to offer surgeons. "It looks like [shrinkage] will have a fairly small indication," he says, "but there was enough clinical interest that we decided even if it's used in only a small number of procedures, we ought to have the tool in our tool box.")

Arthroscopy Competitive Profile

SOURCE: Rodman & Renshaw

An Unforgiving Public Market

In the summer of 1995, with costs rising due to the recent launch of their product, ArthroCare officials suddenly found they needed more money. They talked to both private investors and investment banks before settling on a public offering, with Robertson Stephens as the lead bank, which raised $32 million. "We wanted to do it as inexpensively as possible," says Hira Thapliyal. Plus, he goes on, ArthroCare's senior managers and key investors "all agreed this was not to be seen as a liquidity event. This was a financing event." In fact, even today, ArthroCare's VCs haven't sold off their stock. "Their attitude still is," he says, "that was a financing event and ArthroCare will in the next few years realize its full potential."

That investor loyalty has been helpful because, like a lot of medical device stocks that went public in 1995 and 1996, ArthroCare's stock hit the skids, dropping from a high of $26¼ to a low of $5½. "Two things happened," explains Thapliyal. "First, we got caught in the general malaise where everybody got creamed. Second, we didn't make our numbers." In fact, the two are related: attracted by what had been a very bullish public market over the previous several years, many device companies went public earlier than they historically might have, in some cases, even before they had a product to sell.

Like biotech companies, device companies were selling investors on promises rather than results. But unlike biotechs, who often are valued on other things, such as the perceived value of their alliances, device companies live or die by marketplace performance. With no track record behind them, company executives do their best to estimate what their unproved product will deliver in sales and earnings. If it misses, even by a little bit, investors start looking elsewhere.

In ArthroCare's case, some investors may also have been disappointed when the company failed to deliver on promises implicitly made about opportunities for its device in areas such as urology and general surgery. But it was primarily the missed revenue targets that sent ArthroCare's stock sliding. The company had projected first-year sales of $7 million, $5 million from its disposable wands and $2 million from the capital equipment piece, the small controller which generates the energy flow. But it had difficulty getting customers to buy the controller at its launch price (around $12,500), and company officials worried that it wouldn't be able to drive the growth it needed. Shifting its focus to the disposable wand, it cut the price of the box in order to get it placed in hospitals. "My concern was that we weren't penetrating the marketplace as fast as we wanted to," says Alan Weinstein. "It was important that we took advantage of the fact that we had no real competition [in RF devices] yet. So we started doing placement agreements—if the hospital committed to buying 100 wands, we'd turn over title of the controller to them."

The high volume institutions that ArthroCare targeted, those doing 250 arthroscopies a year, quickly and easily get to 100 wands. As a result, ArthroCare's market penetration is now around 20% and is likely to grow one percent per month for the foreseeable future. But as a result of the strategy shift, first-year controller sales were off by $1 million; overall, ArthroCare did $6 million its first year, not $7 million, and investors reacted negatively. "The good news was we raised all of the capital we'll probably ever need," says Mike Baker. "The bad news is, we went public with virtually no experience about how the product had to be positioned. When you have something like this, you need a couple of quarters of real, live experience selling the product to see what you've got."

ArthroCare officials insist that the missed number is meaningless; selling the controller for significantly less, even giving it away, will result in far greater revenues long-term because it will stimulate sales of the disposable product. Waiting for hospitals to work through their capital investment cycles would slow adoption. Alan Weinstein notes that focusing on the capital equipment sale, ArthroCare had to get over the objection of other buying influences, OR supervisors, who saw this as another piece of equipment to deal with, and administrators who worried about the cost. "But all we really wanted to do was to get the wand in the hands of physicians, to create the critical mass of an established base," he says.

Instead of waiting three or four months for a capital equipment purchase to be approved, ArthroCare was able to get instant access to the market with its products. "We've been able to establish a base [with the shift in strategy]," he goes on, "and it's given us a great platform from which to sell more wands, introduce new products, and make it more difficult for competitors to come in." Still, the loss of nearly two-thirds of the company's stock value hurt. "Psychologically, it was tough," says Hira Thapliyal. "You check the stock price every day, and every time it goes lower, it has an impact on company morale. A lot of my time went into managing our employees' morale. And I'm glad to say that our turnover was very, very low, because everybody believed in the long-term future of the company."

In terms of substantial changes in strategy, Thapliyal argues the stock slide had little effect. Far from catching them by surprise, company officials had already incorporated lower equipment sales into a fundamental strategic shift for the company. But investors were unconvinced. "We tried very hard to explain it to them," says Thapliyal. "But their attitude was, show us the numbers, show us the money."

Arthroscopy Market

SOURCE: ArthroCare Corp.

A Company In Search of a Mission

Mike Baker first heard about ArthroCare when he lived in San Diego, running Medtronic's angioplasty business. A neighbor who was also an orthopedic surgeon knew he worked in medical devices and wanted to know how the industry works. "He had started using the [ArthroCare] device and it worked phenomenally, so he bought some stock in the company," Baker recalls. "He was buying tons of the product, his friends were all buying it, and he couldn't understand why the stock wasn't doing better if the device was so good."

Indeed, Baker argues on, "If you actually looked at what was happening from an operational viewpoint, it made no sense [that ArthroCare's stock price would drop so quickly.]" ArthroCare, he says, "got lumped with other medical device stocks at the time," all of which experienced significant declines from their IPO price. "In reality, the core business was growing very fast, and the company was doing everything it said it would after it made the change in its business plan" to focus on disposables rather than capital equipment.

Baker says that if ArthroCare officials had gone to investors early on and told them that the company needed to spend $3-4 million placing its generators in the top 15% of US customers including every major sports medicine facility, and that within the first two years the device would be used on 100,000 patients, those investors would have responded enthusiastically. "Instead, what we did was perceived as stepping back from the IPO business model, causing profitability to be delayed," he notes. More recently, ArthroCare's stock has rebounded, going over $13, which executives attribute to several things: meeting sales and earning projections for the first three quarters of 1997, the issuance of key patents to cover substantially all of the company's technologies, and a new, more commercially-oriented management team.

Today, given its penetration into the leading sports medicine centers, ArthroCare officials insist that the company could hardly have done better. Baker says that when he first looked at ArthroCare to see whether he wanted to be its CEO, he saw "a core arthroscopy business that was going to do very, very well—it had tremendous momentum, tremendous competitive advantage, great intellectual property protection, and a large, rapidly growing installed base that gave it a very strong market share position." It also faced relatively little price pressure and had positive gross margin in its first quarter of commercial launch, which he says, "speaks volumes about how easy it is to manufacture this and what the potential cost setting might be down the road."

All that, without even touching the international opportunity. (The company recently signed up a distributor, Arthrex Inc., to handle the major European markets and Kobayashi Pharmaceutical Co. in Japan and has distribution in smaller markets such as Canada, Mexico, Brazil, Argentina, and Australia. [See Deal]) Says Baker, "It's unusual that you see a small company that has, with their very first product, hit the ball out of the park."

Still, a perception haunts ArthroCare that it is a company in search of a mission. The early shift away from cardiology, the much-publicized pronouncements that it will have products in a number of different areas, the stock slide, the advent of a new management—all fuel a sense that ArthroCare has still to get its bearings. Says one industry observer, "I know they're working on a number of different things. I'm just not certain they've figured out what [their main business] is going to be."

Winning in Arthroscopy: Increasing Market Penetration

SOURCE: ArthroCare Corp.

A Platform Technology

Company officials understand how outsiders get that impression. "On the one hand, we're saying that our focus is on arthroscopy," says Hira Thapliyal. "And at the same time, in our annual report and other places, we say that we're working in this area and that. It's natural for an investor to say, ‘I think I'll wait until they figure out what they want to be when they grow up.'" And notwithstanding the stock's rebound, Mike Baker believes the unkept promises affected the perception of investors. "This was a young company, with 40 or 50 people, trying desperately to keep up with an arthroscopy business that was taking off like a rocket, and at the same time they kept talking about all these other areas they were going to get into," he says. "Well, it didn't happen as quickly as they thought—time went by and they didn't enter the dermatology business or the urology business. People said, ‘You told us about it last quarter and it hasn't happened and now I don't have faith anymore.' Between changing its business model and not commercializing anything outside of arthroscopy, the stock got driven down to the cellar."

But company officials insist ArthroCare's focus is clear. "We know very well what we want to be and what our potential is," says Thapliyal. We're not groping in the dark." The perception has as much to do with ArthroCare's unconventional approach to medical devices as with early stumbles. Unlike most device companies who target a given clinical specialty and build a business from there, ArthroCare very specifically has developed a technology company officials believe can be used in a variety of specialty areas. "What differentiates ArthroCare from other companies is its size," says Mike Baker, "and that it's not a one-product company. What we have is really a platform technology."

Baker argues that ArthroCare's arthroscopy business has, "by any measure of medical device performance and acceptance, done very well." Just entering its eighth quarter of marketing, he says, "we've already done 100,000 cases. I don't know of many other technologies that have caught on that fast in devices," he says.

Moreover, there's still much untapped potential. Sales for 1998 are expected to double to $12 million, and the company's arthroscopy business will likely be profitable sometime this year. Like many growing companies, much of the increase comes from the launch of new products. "One of the things we've been particularly good at is being responsive to the marketplace," says Alan Weinstein. "Very few of our revenues today come from our original wands. They're really coming from new products and second generation wands."

Then there's the tremendous potential of overseas markets. "There's no reason to believe that we won't in a few years see the same levels of acceptance [in Europe and Japan] that we're now seeing here," says Baker. "We're nowhere near being done at this point." But ArthroCare executives call arthroscopy only a starting point. "It proves the validity of our technology quickly in a large number of cases," says Hira Thapliyal. But arthroscopy itself isn't a billion-dollar business, he goes on. "And there's the potential here for a billion-dollar company." Sometime in the next 12 months, they say, they will announce their launch into a new clinical market. "We are not a one-trick pony," says Thapliyal.

The company has itself over the past couple of years dropped hints about where it might go next, citing general surgery, dermatology, dental, plastic surgery, and urology as potential areas—all specialties which require the kind of clean, precise cut that the company's Coblationtechnology achieves. It has also begun to compile 510(k)s in a number of clinical areas to smooth the regulatory path to new market development.

Alan Weinstein argues that physicians "no longer see [the ArthroCare device] as a fad, but as a viable tool that can be used in other surgical applications." But tapping other opportunities isn't going to be easy. Mike Baker notes that until now, ArthroCare's success has been driven by product performance and an effective selling effort—distributors getting the product into the hands of orthopedic surgeons who themselves find new ways to use the product. "To get to the next level, we have to have much stronger marketing and strategic planning," he says.

For one thing, dramatically expanding the device's capabilities requires a more rigorous effort. "You're not going to go to an orthopedic surgeon and say, ‘I think this device might work with an articular cartilage defect,'" Baker adds. "He wants to see papers and understand the scientific basis for the claim."

In addition, some specialties will respond more favorably to this technology than others. ArthroCare officials note that the device made dramatic improvements possible in arthroscopy and argue there are opportunities to create major markets in other specialties. But some of those other markets may be more modest, depending on the prevailing technologies and competitors, and ArthroCare must choose its markets and plan its commercialization strategies carefully.

Addressing the Skeptics

Finally, even if they identify the right next markets, ArthroCare will face an additional challenge: there's little synergy or leverage between selling to orthopedic surgeons and dermatologists or dental surgeons. As noted, most small device companies target a single specialty;ArthroCare's bet on a platform technology will lead it into different clinical specialties. "The paradigm says that if you are disease-state focused, you have only one product, and if you're in different [clinical areas], you're basically distribution-channel focused, without much innovation," says Baker. "This company changes the paradigm because we're going to master the core technology and then, one indication at a time, come up with a commercialization strategy for different disease states."

Alan Weinstein argues that there are some cross-specialty synergies. "The key arthroscopists know the urologists and talk to them about technology," he says. "So I think we can play on some of the relationships we've developed. We're also establishing some name recognition in the OR because other surgeons see the equipment being used and start asking questions about it."

But realistically, ArthroCare will have to approach each specialty group on its own terms, and in doing so, will have to rely on the technology speaking for itself rather than any kind of leveraged selling effort. "Hopefully, as we go into other clinical areas," Baker goes on, "we not only have a strong proprietary position in the technology, but also a huge base of clinical experience using this technology in humans that will help a dermatologist or urologist understand what's happening to the tissue in front of them [as they experiment with the device.]" That's why the recent patent issues are so important. "We needed the freedom to talk about this, to define what the technology was—that will make it possible to take this technology into some other areas more quickly," he goes on.

ArthroCare's own annual reports have cited areas such as dental and dermatology, urology and gynecology, as logical next markets. But Baker cautions "Don't assume it's going to be one of those—we may do something in those areas, or it may be something else, depending on the timing [of product development]. We're going to be absolutely close-mouthed about what we're doing until we actually do it"—in part, to avoid tipping off competitors, in part as well to avoid raising and potentially disappointing expectations among investors.

ArthroCare officials are aware that a certain degree of skepticism awaits the company. As noted, its own early pronouncements about possible future applications fueled perceptions that the company was somewhat directionless. Baker is enthusiastic about expanded applications, but reluctant to be specific, explaining, "My policy is we won't talk about a product at all until we have regulatory approval, patents filed, and a warehouse full of inventory. When you see us announce that we have a new wand for small joints, it means we actually have one to sell and surgeons are using it in a clinical setting." Talking too much about future opportunities puts pressure on management, he says: "You either create expectations that become disappointments or you end up embarking on a strategy that isn't ready yet or is a second-best strategy just for the sake of doing something. We want to avoid those traps."

ArthroCare won't go into a new area unless it has a strong intellectual property claim, a solid prospect that it will be the only company selling a technology no one else can copy. "As a small company, we can't just slug it out in terms of distribution and price," Baker says. "We need a superior product that is truly proprietary and then we work out commercialization strategies."

But even with its patents and regulatory approvals in place, there are questions ArthroCare will have to deal with. For one thing, orthopedic surgeons have in the past had a disappointing experience with other energy-based devices such as lasers, close cousins to ArthroCare's RF technology. Not only were lasers expensive, but the clinical results were disappointing, to say the least. "Lasers were used in the knee a couple of years back, and there are a lot of patients who have bad knees because of them," says Baker. "The acute results looked pretty good, but the heat killed the vascular bed," he goes on. Even RF technology has had a checkered past, and as a result, he goes on, "Surgeons are now justifiably cautious about using energy devices in small joints and the delicate joint of the knee."

That's why it's important that ArthroCare begin to carefully explain the concept of Coblationand to support the explanation with solid clinical data. Baker argues that it isn't RF per se that makes ArthroCare's system work, but the bipolar grounding of the energy and the multi-electrode ablating surface. "There are tons of RF companies out there," he notes. "This device uses RF, but that's not the point of the device. What we have to do is to convince surgeons that this isn't about RF ablation, it's about volumetric removal of tissue instantaneously."

Still, the reality is, even if ArthroCare makes that kind of distinction, customers and investors may not. As a result, says Alan Weinstein, "We have to educate physicians to make sure RF doesn't get a bad rap and that our approach, using Coblation, is the best way to do surgery."

No Room in the Middle

Hira Thapliyal would like to go a step further: as RF proves itself, as the number of patients treated increases, applications are being found beyond ablation, such as tissue alteration, a reducing of soft tissue. (ArthroCare recently introduced a new wand to do tissue shrinkage.) "RF is coming back," he says. "And ArthroCare is going to be a leader on the ablative front as well as in tissue alteration."

Perhaps the biggest skepticism ArthroCare faces, however, is whether it can turn its technological advances into real business opportunities. "We have the potential for a whole number of different clinical disciplines," Thapliyal acknowledges. "The challenge is going to be, How do we make a real business in them? We clearly can't have a direct sales force in every single specialty." That means ArthroCare is likely to turn to licensing agreements and OEM agreements, depending on the size of the opportunity in each new clinical area, the competitive situation, and how quickly ArthroCare executives feel they have to move in order to capitalize on the opportunity. "There are some areas where your performance advantage over existing products is so compelling you can do it yourself," says Mike Baker. "But timing matters, too. And so we have to ask, where is the practice of medicine [in that specialty] and how rapidly would this technology be adopted? What are the distribution challenges, too?"

"We may even do some spin-outs," says Thapliyal, moving into new therapeutic areas by creating focused companies around the clinical market. Still, the notion that a small device company can create a billion-dollar opportunity today around a single technology flies in the face of accepted wisdom. Increasingly, the device industry seems to be segregating into two camps, large, multi-billion distribution giants, and small, technology-focused, small-cap companies. "There's not much in the middle," notes Mike Baker, who addes, "I think there were a lot of people at Medtronic who were surprised to see me leave because their assumption is that all start-up companies are one-product companies and that the only thing you can do is to sell as much of the product as you can and then sell the company."

But Baker insists he doesn't just want to sell the company. "If all [ArthroCare's board] wanted was someone to come in, get the arthroscopy business established and then sell the company, they didn't need me to do that and I probably wouldn't have left Medtronic to do it," he says. "What we have here is a wonderful product portfolio, an opportunity that is totally untapped, and more cash than we need to capitalize on that. For us to sell the company now, without taking a shot at that opportunity would be ridiculous."

Of course such decisions are often out of the hands even of the CEO. Baker acknowledges that it's entirely possible that ArthroCare will eventually be acquired by a larger competitor. "A reasonable man would come to the conclusion [that a sale is inevitable]," he says. "But frankly that would surprise me. There's still a long way to go in arthroscopy and a lot more beyond that. It's rare to have a technology that is potentially this broad; the more I looked at the technology here, the clearer it became that this was a platform technology, a fundamentally new and different way to do soft tissue surgery that could be compelling in a number of different areas of medicine, not just arthroscopy."

The pressure on small companies is enormous, not just because of their small size, but also because of the skepticism of the public market. Despite his enthusiasm, Baker admits that ArthroCare "has to be realistic about what we can do and in what time frames. We're a company of 110 people. And while I think we have a talented team here, there's a limit to what we can do well," he says. Those limits may be one factor in ArthroCare's decision to partner with a larger company in its next clinical market. "We have to be careful in selecting those opportunities we can do on our own and those we can't," he says. "I think some people worry that a small company with so many opportunities will try to do them all and end up messing up. And I think that's fair. To do some things well, we have to not do other things."

Hira Thapliyal points to a recent article in The Wall Street Journalthat noted that since 1985, 11,000 companies have gone public, 6,000 of which have a market cap under $100 million. "How would an investor find ArthroCare out of those 6,000?" he asks. "That's our challenge. We're going to do it with consistent hard work, met goals, and a long-term perspective. Once we do what we say we can do, we build that credibility. I'm not too worried about it. It will happen."