FINANCE
Creative Company Financing
For medical device companies seeking capital, the need for creativity is serious—and the pitfalls of creativity more so.
Ralph W. Carmichael
The baby boomers are aging. The population is growing. People are living longer and maintaining active lifestyles as they age. Emerging world markets are improving their medical infrastructures. All of these factors are driving demand for medical products worldwide.
The increase in demand for medical products should attract capital to medical device ventures. Or so says intuition. Unfortunately, capital investment in new medical device companies has declined dramatically over the past decade.
Limited access to the capital markets has forced medical device companies to become financially creative. Such creativity can provide companies with the capital to fund growth. However, financial engineering can also destroy a good company. The financial path chosen often determines whether the future holds success or Chapter 11. Certain financial structures may appear attractive but can doom a company to failure. Generally, companies with good business models can avoid the financial structures that lead to tragedy, and will be able to attract capital.
Capital Availability for Emerging Companies
Capital for emerging medical device companies is scarce. In the past 18 months, the venture capital (VC) firms Accel Partners, Crosspoint Ventures, Spout, and Crescendo Ventures have abandoned healthcare investing. In 1999 the medical and healthcare business sector attracted only 5% of all venture capital dollars invested (see Table I). This sector includes medical services and information technology companies, which consumed most of the money invested. Little went to the medical device industry. Why have many investors been shifting away from medical device investments?
| Industry | Number of Companies | Total Invested (million $) |
| Internet | 1237 | 19,888.99 |
| Communications | 396 | 8,547.50 |
| Software | 171 | 7,351.94 |
| Other products | 340 | 4,697.17 |
| Medical/health | 349 | 2,509.30 |
| Semiconductor/electronics | 142 | 1,763.54 |
| Consumer | 169 | 1,598.60 |
| Hardware | 98 | 1,336.18 |
| Biotechnology | 148 | 1,237.55 |
| Industrial/energy | 77 | 971.04 |
| Total | 3127 | 49,901.81 |
To Maximize Returns. Investors seek the highest possible returns on capital. The capital markets are efficient and liquid, allowing investors to shift money quickly. Additionally, investors have numerous investment opportunities. To attract capital investment, therefore, an industry must demonstrate the ability to provide higher returns than other industries. The medical device industry is fundamentally strong, but it offers investment returns that are lower than those of other industry sectors. For example, fiber-optic and Internet investments outpaced medical devices by at least 25% over the past two years. Consequently, investors seeking to maximize returns are not investing in medical device companies.
To Balance Risk and Reward. Investors constantly balance the risk and reward of investments. Early-stage, or venture, capital is the riskiest form of investing. Therefore, VC investors desire returns of 40–60% per year. While these expectations look high, investors need to offset bad investments with some home runs. To minimize risk, investors seek companies with the greatest future revenue potential. Emerging medical device companies target narrow market niches. As a result, projected revenue within three years for successful medical device companies is typically around $50 million. Internet-related companies project revenue in the hundreds of millions of dollars after the same period. Thus, to attract private-equity investors, companies need to demonstrate the ability to generate revenue of more than $150 million within three years. Most medical device companies cannot meet this requirement.
My Baby is Not Ugly!
To start and build a company, people need to be tenacious. However, the tenacity that created the business could limit its growth. Often, managers of early-stage companies do not take criticism well. The company is effectively an extension of the entrepreneurs who founded it. But to successfully raise venture capital, entrepreneurs must be flexible.
VC investors are hands-on types. For their part, entrepreneurs generally are hesitant to share control with investors. However, developing companies all face similar problems and stumbling blocks. VC investors can bring a wealth of knowledge and experience. Seasoned venture investors are accustomed to solving problems that seem unique to entrepreneurs. Investors and management both want the same result: a successful company.
The least-valuable asset that professional investors provide is money. Money can be raised by a variety of methods, and the recent stock market appreciation has created new wealth. Companies seeking capital investment should also evaluate the intangible assets provided by an investor. Does the investor have industry expertise? Is the investor willing to spend time to help the company grow?
Professional investors' time is extremely valuable and has to be used wisely. Venture investors need to allocate time among so-called portfolio companies while also reviewing new-business plans. Usually, most of their time is spent on existing businesses, so new investment opportunities are a low priority for them. Last year, one company spent $10,000 at a charity auction in order to have breakfast with a large venture investor. If a VC investor agrees to allot valuable time to meeting with the head of a new company, the entrepreneur should be humble and listen. Feedback from such investors is rare.
Like everyone else, entrepreneurs never think that their baby is ugly. Professional investors, on the other hand, are outsiders who can evaluate the merits of a company objectively. How the management of the company responds to criticism may determine whether the venture capitalist makes the investment. Flexibility to adjust the business plan on the basis of such feedback is critical. Arguing with potential investors may induce them to turn down the investment opportunity. The new company's managers may be right, but they will have to prove it without the benefit of outside investment.
They Don't Like My Baby!
Most companies that succeed at raising venture capital are turned down at least once. Being rejected is fine if it proves to be a learning experience. To find 3127 investments to make in 1999, the VC industry probably reviewed more than 40,000 business plans. How a company deals with a negative response is important. Constructive feedback should be sought, if possible. If feedback is not available, the entrepreneur must be prepared to consider that the investment probably was rejected because the business plan being presented was incomplete.
Contrary to popular belief, a business plan is not prepared in order to raise money. Actually, if a business plan is distributed for that purpose, it violates criminal provisions in the Securities Act of 1933. Companies should not hire professional business plan writers. The process of preparing a business plan is as important as the final product. In fact, the process may be more valuable. It forces management to examine and focus on the overall business strategy. As the plan is prepared, entrepreneurs should recognize clearly the weaknesses of the company. The process also prepares them to answer investors' questions.
If an investor rejects a company, then management needs to reexamine the business plan—and if necessary, start over. Most entrepreneurs hate this process. However, a complete rewriting of the business plan may be necessary to win funding.
They Want to Steal My Baby!
Inflated valuation is the number one reason that companies do not receive venture funding. Influenced by the inflated stock market, companies develop unrealistic valuation expectations. Private companies have no established market price for their stock. Stock ownership percentages are only important at a cash or liquidity event, such as an initial public offering (IPO), merger, or acquisition. Venture capital investors are very sophisticated at valuing companies. They may seem greedy initially; however, over the period of the investment, VC investors provide management incentive programs that allow entrepreneurs to achieve their financial goals.
An early VC structure might allocate 20% of the company for employee options, 20% for key employees or founders, and 60% for a venture investor. The venture investor generally is willing to have its percentage of ownership reduced substantially—possibly to 35–40%—if the company performs as advertised. Thus, the managers or founders of the company receive stock directly, via the employee option program, and through an incentive plan.
After a brand-name venture capitalist makes an investment, the value of the company increases. The entrepreneurs may own a smaller percentage of the company, but the total company value is greater. Say that prior to the investment the founders own 100% of a $2-million company, and that after it they own 30% of a $25-million entity. Their wealth has increased to $7.5 million as a result of the VC investment.
My Baby Won the Beauty Contest, Now What?
Today, capital for medical device ventures is scarce. But five years ago, numerous venture firms invested in medical devices. The Piper Jaffray (Minneapolis) healthcare fund in 1996 invested 40% of its money in medical technology, a category that includes devices; in 1999, U.S. Bancorp Piper Jaffray sent only 18% that way. Unfortunately, most VC firms were healthcare investors without specific medical device experience. The rubric "healthcare" includes medical services, information technology, pharmaceuticals, biotechnology, and devices. Firms with extensive device experience often are too small to assist companies with future rounds of capital. Thus, numerous medical device companies are thinly capitalized by investors seeking liquidity on their investments.
An idiosyncrasy of medical device venture investing is that future liquidity events for investors are almost always merger or acquisition (M&A) transactions. Most venture firms are oriented toward IPOs. In a recently published article, a partner with Draper Fisher Jurvetson (Redwood City, CA), one of the largest VC firms, was quoted: "Start-ups that focus on acquisition put themselves in a dangerous position. They close off their options. When we fund a company, we always, always focus on an IPO."1 Unfortunately, IPOs are not an option for most medical device companies. Of the 2500–3500 companies that receive venture funding each year, only 200 will complete an IPO. Further, without venture capital backing, most Wall Street underwriters will not discuss an IPO with a company.
The M&A prospects for many medical device manufacturers are also limited. Fewer than 7% of all venture-backed companies have completed an M&A transaction within the past five years. Fortune 500 companies generally acquire companies with at least $50 million in annual revenue. Numerous successful medical device companies will not grow to this size because they serve niche markets.
While venture investors and investment bankers are always discussing exit strategies, companies should not. Companies should focus on the fundamentals of running the business. Exit strategies are a natural stage in the progression of successful business enterprises. If a company demonstrates accelerating revenue growth and future profit potential, Wall Street and competitors seeking acquisitions will both notice. As a result, options such as M&A and the IPO will appear. If the company only focuses on exit strategies, however, the business will not develop.
My Baby Wants an IPO!
An initial public offering by a reputable Wall Street underwriter is an exciting event. However, the odds of completing a successful IPO are comparable to being struck by lightning. In the past five years VC firms have backed 12,157 companies (and rejected 20 times that number), of which only 971 completed an IPO. Fewer than a third of the companies that completed IPOs since 1990 are trading above their initial offering price. Also, 87% of the money raised in IPOs came from the top 10 investment banks, which generally consider only venture-backed companies for IPOs.
Even in today's hot IPO market, very few medical device companies are even considered by the large Wall Street underwriters. Some investment banks have recently been purchased by larger financial institutions. Prominent among the acquisitions are Alex. Brown (Baltimore), Piper Jaffray, Montgomery Securities (San Francisco), Hambrecht & Quist (San Francisco), and Robertson, Stephens (San Francisco). As a result, the number of IPO underwriters has been reduced, and the minimum size of transactions that will be considered has increased. Five years ago, underwriters would consider a $25-million IPO. Today, they would not.
Medical device companies faced with limited IPO and M&A prospects may begin to consider nontraditional financial structures. Companies that are desperate for liquidity for investors are vulnerable to disreputable so-called investment bankers who prey on them. These charlatans make grandiose promises of IPOs using unique financial structures and propose alternative methods to go public. They use backdoor methods to raise capital and go public in order to avoid scrutiny by the Securities Exchange Commission (SEC). For example, they often suggest "Reg S" (offshore) offerings, transactions that the SEC has severely restricted, or reverse mergers (see sidebar). While these suggestions may sound attractive, they rarely work.
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A common nontraditional public offering is the two-step reverse merger. The first step is to identify a likely public shell company. Shell companies often have a sordid past (bankruptcy, for example) and are in businesses unrelated to that of the company desiring to go public. Sometimes they even come with shareholder litigation. The second step of the process is to merge the private company into the shell company. Usually, shell companies have a token amount of cash, and the investment banker who proposed the transaction promises to raise additional capital after the merger. Sometimes this capital materializes. Any investment banker who suggests a reverse merger, however, should be suspect. Reputable bankers do not promote the use of reverse mergers, and the SEC frowns upon them. Limited Capital Access. Companies that use reverse mergers to become public have limited access to capital. The promoters of these schemes generally can raise a few million dollars. However, little capital is left for the company after the fees are paid and the promoter is gone. To attract investors in the public markets, companies need to have numerous market makers who provide the liquidity for trading the company's stock. Typically, reverse-merger shells have no more than one or two market makers. Once the company is public, the universe of institutional investors is limited. Most VC investors are prohibited from investing in public companies. Also, these companies usually are traded in an over-the-counter market, such as the "Bulletin Board" or "Pink Sheets," that has limited liquidity for investors. Stock prices on these markets are thus usually below $5 per share. Most institutional investors are prohibited from investing in stocks priced below that figure. It is also worth noting that the limited liquidity inherent in reverse mergers makes it virtually impossible for company managers to sell stock. New Responsibilities. The reverse merger brings a company all the disadvantages of being public without the benefit of access to capital. Public companies face costly reporting and administrative requirements. Also, managers of public companies have to respond to inquiries from disgruntled shareholders. These shareholders may have lost money on their investment. Sometimes they purchased the stock on the basis of false representations by brokers. Even though its management was not involved in the stock sale, the shareholders may still hold the company responsible. Litigation could result. Death Spiral. Most reverse mergers also unnecessarily create complicated capital structures for companies, sometimes called death spirals. Such a capital structure includes numerous classes of convertible preferred stock and warrants. The dilution to common shareholders of these classes of stock and warrants—the overhang—is extreme. A company with 1 million common shares outstanding may have an overhang of 50 million shares. These structures are called death spirals because the companies are diluting shareholders faster than they are growing. Needless to say, investors shy away from these companies. |
A structure known as a PIPE (for "private investment in public equity") was recently created to provide capital for small public companies in need of investors. While PIPE transactions may be necessary, they are generally very dilutive to existing shareholders. Most PIPE deals are convertible preferred stock, priced below the current market value, and have additional warrants for up to 100% of the amount of the financing. For example, say the current public stock price is $5 per share and the company raises $5 million. The PIPE may be 1.5 million shares of preferred stock convertible at $2 per share, and the investors involved additionally would receive a warrant to purchase 1.5 million common shares for $2 per share. The case is usually that, shortly after the PIPE transaction is closed, the investor exercises the warrant or converts the preferred stock and sells enough shares in the public market to recoup the initial investment.
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A common misconception is that people get rich with an initial public offering. In a hot IPO, investors make money. However, the IPO does not create the money. The IPO only provides liquidity for investors. Only companies with notably attractive future prospects complete successful IPOs. Also, managers of public companies are usually restricted from selling stock. So even if investors make money, company executives may not be able to do so by selling their shares. |
There's Hope for My Baby
Capital is available for good medical device companies. Certain private-equity/venture capital firms have allocated funds for medical device investing. Books such as Pratt's Guide to Venture Capital Sources can help companies find VC firms.2 Reputable investment bankers can also help companies raise VC money. Companies that are able to attract venture capital should take the money. They should not allow the transaction to fall apart over valuation. In the long run, the valuation is usually acceptable to all parties. If the company is rejected at first, it should evaluate its business plan. Altering the proposed business model may result in funding.
Companies seeking less than $5 million of capital investment should consider pursuing what is known as angel financing or else should approach small business investment companies (SBICs). Angels are high-net-worth individuals who invest in private companies. Most metropolitan areas have organized angel networks. Generally, these networks of investors meet monthly to hear company presentations. Prominent lawyers and accountants can refer companies to these networks. SBICs are licensed by the U.S. Small Business Administration (SBA). Although SBICs are a significant source of capital, they generally do not make large investments in private companies. SBIC investments in private companies usually top out at about $1 million. The SBA has a Web site that lists all of the SBICs.
If VC firms reject a company, alternative types of financing are available to it. However, bank financing is usually not an option; growth-oriented companies are not considered bankable. But as a company grows, bank financing may become available. Rather than wasting time with banks early on, companies may want to consider commercial lenders such as Finnova (Phoenix). These institutions generally will lend money against assets or, possibly, future cash flow. They also recently have begun to lend money and take intellectual property as collateral.
Strategic alliances between large and smaller companies have become common. Most large medical device companies have capital to invest. These large companies use this capital for an extension of their own research and development activities. Also, emerging companies may wish to consider a potential merger or acquisition transaction that provides additional capital for the company.
Conclusion
To avoid having a dream become a disaster, emerging medical device companies should focus on building a strong business rather than depend on financial engineering. Capital for device companies may be scarce, but investors are still looking for quality companies. Investors prefer companies with proprietary technology and strong management teams.
Companies should be cautious of IPOs and keep their capitalization structure simple. An IPO can be the greatest event in a company's history or it can be a nightmare. A company should consider arranging an IPO only with a top-tier investment bank. A medical device company needs to demonstrate the ability to generate $100 million of annual revenue within two years for an investment bank to consider underwriting an IPO.
To end on a positive note: The capital markets are healthy and capital is available. The $2.5 billion invested in healthcare in 1999 compares favorably with just $547 million in 1995.
References
1. Geoff Baum, "A Strategic Mistake," Forbes ASAP (November 29,1999): 46.
2. David Kwateng, ed., Pratt's Guide to Venture Capital Sources (New York: Security Data, 2000).
Ralph W. Carmichael, JD, is founder and principal of Carmichael & Company LLC (New York City), an investment bank that specializes in medical device and telecommunication industries.
Illustration by Barton Stabler/SIS
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