In full surgical attire, R. Sterling Hodgson, an Oregon neurotologist—a surgeon specializing in hearing and balance disorders—peers through a microscope as he drills into a cadaver’s skull. The bone lab where he’s working is located in an industrial building in White Bear Lake occupied by Envoy Medical, a small medical technology firm. Hodgson is practicing a procedure that will allow him to implant a new device developed by Envoy Medical. Branded Esteem, it promises to restore hearing to those with severe to moderate hearing loss, without external aids. Before Hodgson can perform the procedure on his own, he needs to prove his proficiency.

“It’s a challenging surgery,” says Hodgson, who has two patients waiting for him to complete training. “I’ve been surprised at the level of precision it requires.”

Hodgson is one of about 60 U.S. surgeons who have either finished or are currently in the process of taking the training, which typically is spread over several sessions and takes about eight full days to complete.

In February, Envoy Medical obtained Food and Drug Administration approval to market Esteem in the United States. Fifteen years and $120 million in development, Esteem is modeled upon implantable pacemakers, to which it bears a strong resemblance. Unlike hearing aids, which incorporate tiny microphones to amplify sound, the device turns a person’s eardrum into a kind of natural microphone, allowing the brain to process a wider variety of sounds than “artificial” mics can pick up.

Though left for dead by some early investors, Envoy Medical has retained a core group of believers. Some are among Minnesota’s most successful entrepreneurs: Mankato-based printing-business billionaire and Minnesota Timberwolves owner Glen Taylor; Ken Dahlberg, founder of Miracle Ear and inventor of the first in-the-ear hearing aids; and Roger Lucas, founder of Minneapolis-based Techne Corporation, which owns two Minnesota biotechnology companies.

“I think [this technology] will replace a substantial share of the hearing aid market, but it will be gradual,” says Dahlberg, who owns about 3 percent of Envoy Medical. “Once people buy this, they are off the hearing aid market forever.”

But first, Envoy Medical needs to build its own market. Surgeons need to sign up to learn the procedure. And hard-of-hearing people need to be convinced that the $30,000 they’ll need to pay for Esteem and the surgical procedure—neither the device nor the surgery, with a few possible exceptions, is covered by insurance—is worth the cost.

Building Esteem

Lucas, a founding shareholder who’s currently Envoy Medical’s board chair, stumbled across the company and its technology while looking for something else. In November 1995, he was chatting with an independent technology broker working for the University of Minnesota. That discussion was interrupted by an incoming call that Lucas needed to take. The next day, when Lucas called to continue the conversation, the broker mentioned he had just returned from showing office space to Ted Adams and Bruce Brillhart, two former Medtronic employees who’d founded a new company called St. Croix Medical. Adams and Brillhart told the broker they owned a technology that could restore hearing.

Intrigued, Lucas got in touch with the start-up’s founders. “They had this device, and they drew it out on the back of the proverbial napkin,” he recalls. Impressed by the technology, “I immediately wrote them a check for $150,000.” A risk taker by nature, Lucas also had a personal reason for investing in the company: “My father and grandfather were hard of hearing, so I knew it might affect me and my children someday.”

The technology was invented nearly 10 years earlier by Don Schaefer, a Wisconsin entrepreneur and audiologist. Schaefer (who died in 1990) believed that hearing aids, being basically little more than microphones and speakers, didn’t do such a fantastic job of helping people hear better.

“Microphones gather all sound, and speakers, when turned up, typically send a distorted message,” says Shelly Amann, Envoy Medical’s president. “Don understood that by using [a person’s] eardrum, patients would receive the clarity that people with natural hearing enjoy.”

Lucas, who says that he “kept falling more and more in love with the company,” also kept pouring more and more money into it. Today, he owns about 18 percent of the company, or 22.5 million shares, which were valued at about $4 each in mid-June.

Basketball legend and former Minnesota Timberwolves head coach Kevin McHale learned about St. Croix Medical from his brothers-in-law—Patrick, Michael, and Daniel Spearman, who at that point had $5.25 million invested in the company. The Spearmans are veteran entrepreneurs who sold their first company, filter maker Porous Media, to Minneapolis-based Pentair for $225 million in 2007. Their second, Lexion Medical, has 100 employees and shares a building with Envoy Medical, the more universal-sounding name that St. Croix Medical assumed in 2006.

In May 2000, McHale invested $200,000, then watched as the company faltered the next few years. “I thought, ‘There’s some good money that went bad,’” he recalls. “But I knew the technology was still good.” He kept his shares. He and his immediate family now own about 1.5 percent of the company; the Spearmans hold 34 percent.

In 2003, the company was about to do a reverse 10-to-1 stock split, which would have diluted the share price by 90 percent. Unwilling to see his share price decimated, Patrick Spearman convinced the board to let him try finding new investors. Through the McHale connection, Glen Taylor topped Spearman’s list of possible investors.

Taylor liked what he heard. “It tickles my heart emotionally to hear the stories of people who have been helped by the technology,” he says. “It is life-changing for people.” Taylor also was impressed with the other investors: “The three Spearman brothers were nuts-and-bolts type of people. They watched expenses. They thought long-run, and there was a place and a need for someone like myself. I could help in the business practices.” Today, Taylor owns 15 percent of the company.

Once Taylor invested, Lucas and the Spearmans upped their stakes. At one time, Medtronic owned 20 percent of the company, but the Fridley-based med-tech giant sold its shares three years ago. Cofounder Adams has also cashed out, while Brillhart retains a small stake.

Building Esteem took years of trial and error. In 2002, the company completed a feasibility study; two years later, it initiated clinical trials in the European Union and in the United States. In 2006, Envoy Medical was cleared to market its device in the European Union. As of mid-May, physicians had implanted 150 Esteem devices in 10 foreign countries—50 implanted in paying clients (versus patients in clinical trials). There have also been 50 devices implanted in the United States, all but five in clinical trials. But the “big enchilada,” as Patrick Spearman, now Envoy Medical’s CEO, puts it, was FDA approval.

Sound Strategy

According to the Better Hearing Institute in Washington, D.C., about 31.5 million people in the United States have at least some hearing loss. Of those people, more than 90 percent suffer from sensorineural hearing loss, which results from problems that originate in the inner ear, the auditory nerve (which runs from the inner ear to the brain), or in the brain itself.

People with sensorineural hearing loss lose their ability to hear faint sounds as well as to understand speech. Disease, injury at birth or later in life, drug toxicities, genetic syndromes, viruses, and aging can all cause sensorineural hearing loss, but the most common cause is repeated exposure to loud noises.

Envoy Medical’s target market comprises people with moderate to severe sensorineural hearing loss—about 18.5 million people, or more than half of all people with sensorineural hearing loss. A good-sized target, in short.

But there’s a hitch: The Esteem device costs $20,000, and patients have to pay another $10,000 for the surgery. Compare that to the cost of a typical hearing aid, which runs about $2,000. Hearing aids typically last about five or six years before they need replacing. Esteem requires that its sound processor be changed on average every seven years as its battery wears out. A new, upgraded processor costs $6,000, which includes the cost of the surgery. And like nearly all hearing aids, Esteem isn’t covered by insurance (though Amann says that some insurers are starting to chip in for a portion of it).

“It’s expensive,” Taylor acknowledges. “We have to learn how to drive down costs.”

In order to do that, “We brought everything in house that we could to keep costs down, quality up, and ensure product availability,” Spearman says. Envoy Medical manufactures the device at its White Bear Lake headquarters, where it employs 50 people. (Ten other employees are stationed across the globe to manage sales.) The company has its own call center and all sales of Esteem are direct to its network of trained physicians. Envoy Medical will also open a surgical training center in Houston in August.

The company says that all of the implants done so far have been successful. “The patients that I met who had it done survived and were hearing by their estimation quite well,” says Bill Austin, founder of Eden Prairie–based Starkey Laboratories, the largest manufacturer of hearing aids in the United States. “They were doing fine, and I would consider these patients a success.” Austin adds that at this time, his company has no plans to pursue a similar, competing technology.

To help overcome the lack of insurance coverage, Envoy Medical offers its own financing. “Just last week, I got a call from a waitress making less than $40,000 a year,” Lucas says. “When she found out we’d finance it and what the payment would be, she said, ‘That’s my car payment. I’ll just hang onto my car a while longer.’”

Lucas originally believed that the market for Esteem comprised people like his father, who started to lose his hearing at age 72. He now thinks that young people with sensorineural hearing loss are the most likely candidates. “They seclude themselves,” Lucas says. “They withdraw and find jobs where hearing is not important—probably low-paying jobs.” The company is betting that $30,000 will be a small price tag for people facing decades of hearing problems.

Esteem’s price may also shrink as the device undergoes more iterations. “We don’t think we have the ultimate product,” Taylor says. “We think there will be new versions of the product that will be even better. We have the foundation, but a very good foundation.”

IPO Ahead?

In early May, Envoy Medical launched a nationwide marketing campaign. It has begun running television ads in 19 U.S. cities, primarily on news stations. A radio campaign also is in the works.

To maintain its marketing and development efforts, the company needs more investment—even in addition to the high-profile, big-money supporters already behind it. “We have never looked for money from venture capitalists, and we are not big fans of venture capitalists because they always want preferred shares,” Spearman says. All of Envoy Medical’s shares are common stock. “We are only going to accept angel money,” Spearman adds.

If not enough angels give their blessing to the enterprise, Spearman says that he and the other shareholders will put more of their own money into Envoy Medical. The controlling group of shareholders has no intention of selling out to a larger company, Spearman adds.

This summer, Envoy Medical began working on U.S. Securities and Exchange Commission filings for an initial public offering. As of mid-June, Spearman expected an IPO to be completed within 18 months. “By that time, we’ll have enough expenses and enough sales so that when investors exit, they can exit at a fair price,” he asserts. Assuming 40 percent profit and a price/earnings ratio of 30-to-1, Spearman calculates a market cap of $5 billion.

Meanwhile, Envoy Medical is seeking to train top physicians on the surgical procedure and make sure only those patients who can benefit from the device are chosen as implant candidates. “Performance in the first year needs to be top-notch,” Taylor says. “At this stage, we have to perform. I’m confident we will.”

Spearman estimates Envoy Medical’s 2010 revenue at $10 million and 2011 revenue at $50 million. As of yet, no other company has started to develop a technology to compete with Esteem.

That may change, too. “It’s inevitable that we will get competition, because this development is profound,” Dahlberg says. “It is an absolute threat to the hearing aid industry as we know it.”

Getting “Turned On”

Mahtomedi resident Amy Pajula remembers the day she was “turned on.” It was eight weeks after Greensboro, North Carolina, surgeon Eric Kraus implanted Envoy Medical’s Esteem device in her left ear. The mother of two sat across the table from a hearing engineer from Envoy Medical and an onsite audiologist.

“The first thing I heard was the ventilation system,” Pajula recalls. “I had never heard that before. It was a soft hum. I couldn’t believe the clarity. It was extremely emotional for me. I left with my hearing.”

Pajula, who has severe to moderate sensorineural hearing loss in both ears, began to lose her hearing at age six. By the age of 13, she needed aids, but she refused to wear them. “I was really embarrassed about it,” she says. Pajula tried in-the-canal aids in college, but her hearing loss was too severe for them to work. When she had her first child at age 26, she gave in and purchased behind-the-ear aids more suited to her condition. Even so, Pajula still often relied on lip reading and on closed-captioned TV. In 2005, Pajula lost one of her hearing aids; four months later, she lost the other. While searching on line for new ones, she came across information about an upcoming clinical trial for the Esteem device. So far, Pajula says, she’s been delighted with her serendipitous discovery.