The statistics look grim for start-up companies. Some 50 to 80% of new products are unsuccessful, and start-up companies fail at a rate of 85% on average.1 While it's enough to deter even the boldest entrepreneurs, these figures are particularly frightening for life science firms because exorbitant R&D budgets inflate the price of failure.
Attracting venture capital funding is a necessity for start-up companies aiming to secure a foothold in the medical market, which is ripe for investment despite the plentiful risks. The U.S. medical-device industry has high profit potential.2 It's valued at over $86 billion and estimated to grow 8 to 10% per year. The lure of significant return multiples on investment provided by the next breakthrough product continues to attract venture capitalists.
The pitch to venture capitalists
A key to raising funds from venture capitalists is to understand the objectives of their funding. For example, the invested capital must provide a significant return within a relatively short time frame. A common expectation is a return multiple of three to five times the post-money valuation with a timeline to realize their return with an exit in three to four years and an addressable market in excess of $500 million. Entrepreneurs must understand that venture investors are not solely in the game to advance medicine and help patients. While the sentiment is noble, the venture investor's principal objective is to earn a profit, or provide at least a 20% internal rate of return to their limited partners over the fund's life, about 10 years. Conversely, entrepreneurs have the vision and belief in the potential of the proposed innovations to change the way medicine is practiced.
As part of this process, the entrepreneur must make an initial presentation to the investors. This meeting will be brief. Many dreams never see the light of day if an entrepreneur cannot convey the potential for market adoption, ultimate exit, and profitability for the venture investor. Leading life-science venture capital firms may hear hundreds of presentations each year and dedicate just minutes to screening new proposals. The entrepreneur may only have one chance to pitch a deal so homework is essential prior to the initial meeting. At a minimum, the entrepreneur should know the venture firm's historical interest in various deal stages and in areas such as orthopedics, cardiology, or therapeutics. Other important issues are the venture firm's fund status, past deals, current portfolio, and whether or not they typically lead investment rounds or prefer to follow.
One can anticipate that pre-money valuations associated with a Series A investment will provide the entrepreneur with an ownership level in the range of 25 to 35% post-money. Of course there are exceptions. The entrepreneur will forfeit majority ownership and relinquish control, but will receive the needed capital, introduce venture expertise through years of experience to the Board of Directors, position the company if necessary for subsequent rounds of financing at potentially a higher valuation, and ultimately build tangible value for all involved.
The drivers of diligence
It is essential for the entrepreneur to concisely convey the potential of the proposed technological innovation during the initial presentation. Here, the entrepreneur must point out its “use-incentives” such as how the technology will change the way medicine is practiced from the physician and patient points of view, and from a financial perspective. The physician's benefits may include increased efficacy, reduced morbidity, and more efficient operations management. These attributes can be logically extrapolated to the patient, as can additional benefits such as transitioning a treatment from an invasive surgical procedure to a minimally invasive approach or shorter healing times. Most of these will equate to financial incentives. Articulating these incentives is necessary for the entrepreneur to “get past go” with a potential investor, and that is when the real diligence begins.
After the venture capital firm recognizes the technology's potential, the entrepreneur must tell how he or she will use the funds. R&D and engineering may consume the first 18 to 24 months of the venture and use a large portion of the funding, therefore investment success is largely contingent on a sound, innovative R&D plan. While the “make or buy” decision has long been faced in manufacturing, it is becoming increasingly common for start-up firms to outsource part or all of their R&D operations. External design-and-engineering firms offer many benefits and offset much of the risk inherent in start-up operations. This is evident after evaluating the common investment evaluation metrics used by venture capital firms.
For example, practical innovation is essential. Even the most innovative product can fail if it does not meet market needs. The particular target clinical indication and the applicable market size for the technology must be evaluated for the real clinical utility being proposed. End-users must be involved. Venture investors no longer take a physician inventor's perspective as gospel.
To address the issue, some venture firms have taken proactive physician feedback to a new level. This entails aligning physician and investor interest at the onset of the process when it is believed clinical expertise is most needed. Coupling the prospective end-user with a venture firm and physician feedback at the onset in proactively evaluating and addressing needs with a specific deal provides an execution-driven model for the funded start-up. This clinical “quality check” can maximize development efficiency, flexibility and ultimately provide the investors with a higher degree of risk minimization.
Entrepreneurs must understand the addressable market, including comparables with respect to existing players along with how they penetrated the market, historical adoption drivers, information on how the market may be changing, new potential players and existing competition. Identifying market leaders provides venture investors with an understanding of a possible exit strategy, something they will consider at the onset. Market leaders are also firms most likely to acquire the start-up company. Their acquisition history can identify value inflection points when they will occur, why the new company would be of interest, and its relevant valuation.
One benefit external design-and-engineering firms offer is to forecast whether a proven medical technology will live beyond its initial purpose and be advantageous in the future. Technology forecasting is critical in shaping the start-up firm's strategic position. External partners attuned to the new needs of the medical market can help the entrepreneur understand if and how the idea addresses end-user needs. Additionally, outside firms can conduct pertinent market research through interviews, focus groups, and surveys to help prioritize end-user needs and minimize the risk of developing a product with unnecessary features or costs. Outside partners also lend anonymity to the project. This lets the start-up and investor obtain first-hand feedback while maintaining confidentiality.
In addition, venture investors must understand how the innovation can be manufactured. An unmanufacturable design can delay a product launch and mire the project in costs, possibly lowering the investment's return. Soon after developing the medical device concept, the entrepreneur can leverage its partner's know-how to select the best manufacturing approach and determine if standard or customized equipment is ideal. This approach prevents costly mistakes and production mishaps that might delay market introduction.
An effective design is often reliant on multidisciplinary problem solving, another plus for design and engineering firms. Skilled project teams with diverse backgrounds can apply technologies that might be uncommon to a life sciences firm, but necessary for developing a successful medical product.
Regulations and reimbursement
Gaining product market share often depends on its prospective payor reimbursement strategy. Many venture investors do not consider a technology unless an established reimbursement path exists. Entrepreneurs on the other hand, often consider FDA clearance or approval as the primary benchmark of a successful venture, however it is equally important to garner reimbursement for the product. Because navigating reimbursement diligence can be difficult, venture firms often seek out expert assistance. Entrepreneurs should do the same to establish a cogent strategy to present to prospective investors.
Regulatory strategies should be addressed early, because much time, effort, and capital will be spent post-investment addressing regulations facing the medical device start-up. The regulatory strategy can be fraught with many unknowns such as overall requirements, substantial equivalence comparables, clinical-trial design, and primary efficacy clinical follow-up, all of these must be incorporated in a preclinical and clinical plan, and a pro forma budget. Leveraging the contacts of experienced engineering partners and instituting a proactive approach in communicating with the FDA can help significantly reduce the unknowns. This will lead to an easily defended budget and a higher degree of credibility for the prospective investment deal.
Minimizing risk through partnerships
Venture capitalists understand there is no start-up without risk. Yet firms considering an investment in medical start-ups need assurance that they have taken the time to minimize potential risks such as costs, confidentiality, and capital investment. The entrepreneur must understand and convey the potential obstacles that lie ahead and how the company can best anticipate and meet these challenges. Seasoned investors often assess the risks associated with an opportunity during initial presentations or even from reading executive summaries. The entrepreneur's challenge is to communicate that these risks have been considered and a plan established to best operate the business.
The venture investor must also be comfortable with the entrepreneur's ability to compile a management team to address risks and build value for the enterprise. To complement their internal team, entrepreneurs can demonstrate this viability by partnering with a design and engineering firm that provides a team of experts with managerial and multidisciplinary expertise.
Outside firms might also be more economical than hiring full-time or temporary employees, or consultants who may present confidentiality risks and financial burdens. Third-party firms can cost-effectively dedicate a multidisciplinary team. Experienced engineering firms can often benchmark a start-up's ideas, giving comfort to venture capitalists looking for an investment insurance policy.
The bottom line
Medical-device entrepreneurs gain an increased position of strength when approaching fund raising by establishing a business plan that incorporates the facets of the diligence metrics described above, along with understanding options for outsourcing partnerships to maximize efficiency and minimize risk. Having a proactive grasp of the perceived risk and taking steps to minimize it indicates competent management and should prove to increase valuation for the investment opportunity.
A well thought-out plan that includes partnering with an external firm helps fill in the technology gaps of a company's own medical market experience, giving potential investors the comfort of knowing the risk of losing money is minimal. The right partner can help position medical device start-ups to easily claim market leadership by providing guidance through the process of adequately monitoring the competition, leveraging technology forecasting, and taking steps to protect their proprietary products with patents held in the company's name. With these strategies, medical device start-ups will define themselves as viable entities well worth the investment.
How to differentiate a start-up
Medical design start-ups face intense competition for a finite amount of funding. So it makes sense for a company to differentiate itself from the other companies looking for funding. One way to do so is to outsource some portion of the product design and development to a firm that taps into a high degree of proactive end-user feedback. Minimizing risk while strengthening the probability of bringing practical innovation to market quickly is a strategy that can improve a company's attractiveness for investment, and build value for subsequent market penetration and success.
A brief guide to the VC vocab
Like engineers, venture capitalists have a vocabulary that describes the details of their work. The definitions below coincide with terms in the article.
Comparables: Terms used to denote similar companies, companies in the same space, or in the same situation.
Mezzanine stage of investment: A later stage investment provided to a company that is producing and selling a product, to facilitate increased profitability, acquisition, or initial public offering. Mezzanine investment financing provides for major expansions in companies with increasing sales, and whose cash flow is break-even or slightly positive. Investors entering in this round typically have lower risk of loss than those investors who have invested in an earlier round.
Post-money valuation: The valuation of a company immediately after the most recent round of financing. This value is calculated by multiplying the company's total number of shares, including incentive stock options, by the share price of the latest financing.
Pre-money valuations: The valuation of a company prior to a round of investment. This amount may be determined by using various calculation models, such as a multiple times a future cash flow discounted to a present cash value and a comparative analysis to comparable public and private companies.
Pro forma budget: A projected budget that includes all business expenses such as salaries, research and development, and sales and marketing related to operating the company.
Seed stage of investment: Generally, the stage at which equity is supplied to support the financing of R&D activities and the development of initial business concepts. The seed stage is important because it is when the proof of principal is established.
Series A investment: The first round of professional equity financing for a start-up company. For example, a Series A investment for a medical device company is usually in the $5 million to $10 million range. Should the company need to raise additional money through another round of venture equity financing, this is referred to as a Series B financing (later rounds of financing in a private company are called Series C and so on).
Value inflection point: Milestone achievement at which time the company is considered more valuable.
Strength from outside management
Entrepreneurs must also prove strength in a long-term plan that shows a transition from business concept to market-leading medical solution. Start-ups that partner with outside experts at the onset of product development relieve the start-up of administrative burden from taking on more than they can handle and ensure meeting market needs and business goals. Engineering partners complement management addressing administrative necessities such as:
Venture investors require that medical device start-ups have a clear research and development milestone plan, timeline, and an understanding of the financial commitment including a sensitivity analysis necessary to clear the regulatory approval milestones such as FDA and CE (Conformité Européene) marking requirements, all necessary to get the product to market. Start-ups should consider critical paths to market that include the possibility of using outside firms with expert personnel to augment in-house staff, whether for pure research, development execution, engineering or industrial design.
As with any investment opportunity, pro forma financials are a cornerstone of diligence. In addition, to get a technology to market, the medical device start-up must have a budget that takes the company to cash-flow breakeven and beyond. Inherent in this budget is the prospective cost of goods, where the compony's strategy for manufacturing must be outlined. Whether it entirely entails contract manufacturing, an initial plan for contract manufacturing evolving to an in-house effort, or entirely in-house, this must be established as part of the financial model. Thus, it will be important to foster a relationship with potential contract-manufacturing candidates and attain an estimate, regardless of the stage of the technology, on transfer price.
Intellectual property protection
Another decisive factor for the entrepreneur to consider is the scrutiny the potential investor will exhibit in reviewing the existing and prospective intellectual property estate. The diligence process often involves the investor and legal counsel conducting a freedom-to-operate review. The investor will also meet with patent counsel to understand the current intellectual-property landscape and how best the company can surround its technology with more protection, after which a deeper dive into this area may be taken in the diligence process. Establishing a continued intellectual property strategy for the start-up company with associated expenses is anticipated by the investor. The entrepreneur must articulate a plan for such protection. An engineering partner well-versed in IP issues can also guide this process.
Venture-capital investments in the life sciences
|Software and information services||5|
|Medical imaging equipment||2|
|Diagnostic equipment (not imaging)||11|
|Therapeutic devices (minimally and non-invasive)||23|
|Therapeutic devices (invasive)||35|
|*Dow Jones Venture Source|
“The Essentials of Consumer-Driven Innovation,” Forrester Research: May 26, 2006.