Originally Published MX May/June 2001
Finance
Going Up?Angel investors offer perspectives on what it takes for medtech entrepreneurs to get funding.
Flora Nguyen
Anyone doing business in the medtech arena knows how tough it is to get funding in today's bear market. Venture capitalists (VCs) are suddenly gun-shy when it comes to investing in high-technology industries, thanks to recent New Economy losses ranking in the tens of millions. These losses have also made many VCs impatient in their investing. According to the National Venture Capital Association (Arlington, VA), VCs these days generally want to see a tenfold return on their investment in three to five years. However, the regulatory and reimbursement hurdles that medtech companies have to overcome before they become profitable make such a timeframe for liquidity highly unlikely. Consequently, VC funding in the medical technology industry has consolidated in the last few years.
Many medical technology entrepreneurs, however, might not be aware that personal private equity—and not VC funding—is the richest source of capital available to them. The most well-known type of private equity comes in the form of an angel—or 250,000 angels, to be more precise. Data from the Small Business Administration (Washington, DC) indicates that there are more than 250,000 angels in the United States, who invested approximately $100 billion in 1999—mostly in seed, start-up, and early-stage ventures. By contrast, the National Venture Capital Association reports that only 3600 early-stage companies received $20 billion in funding from approximately 500 VC funds in 1999. The early-stage medtech entrepreneur may therefore have a better chance of raising funds from angels than from VC firms.
Keeping such statistics in mind, this article focuses on angel investors, discussing the advantages that they can bring to medtech start-ups, where to find them, and how to get them to invest in your company.
In a League of Their Own
So what, exactly, is an angel? According to Ian Sobieski, PhD, managing director of the Silicon Valley–based investing group the Band of Angels, angels are high-net-worth individuals who invest in private, early-stage companies with their own capital. VCs, on the other hand, manage money for outside investors in their venture fund. "By definition, then," Sobieski explains, "the VC is a professional investor, while the angel is an amateur. This distinction is important, and it's one that many angels recognize. It can make the investing approach of the angel much less formal than that of a VC, and sometimes better suited to the needs of early-stage companies."
Just how is an angel's approach to investing less formal than the traditional VC's? "The VC's job is to make money for his investors and to achieve returns in a reasonable time frame," says Paul Auerbach, MD, a partner at the VC firm Delphi Ventures (Menlo Park, CA) and life sciences advisor for Garage.com (Palo Alto, CA), an angel investor network focusing on early-stage companies. "When considering an investment, VCs carefully screen the technical and business merits of the proposed company and focus intensely on management, as they are required to make periodic formal reports to their investors. The angel, on the other hand, does not have to report to any investors and is free to determine a personalized investment strategy."
Money Isn't Everything. While all angels want to make money, it isn't necessarily the sole driving force behind their decision to invest. "Many angels are retired CEOs or heads of industry who invest because they want to stay in the game by helping start-ups grow," notes Sobieski. Because most angels derive personal gratification from their involvement with the companies they choose to invest in, he explains, they are less driven by the need to make money than VCs, and are often motivated by the energy of a young company. It makes sense, then, that angels will oftentimes take into consideration the level of enthusiasm that the entrepreneur exhibits about his company.
"One of the qualities that we look for in an entrepreneur is an excitement that's contagious," says Kurt English, founding principal of Angel Strategies LLC (Aliso Viejo, CA), an investment company whose founders have extensive backgrounds in healthcare. "This is especially important in the medical technology industry, where the most successful entrepreneurs are often visionaries driven by their desire to help thousands of people afflicted with a certain illness."
No Risk, No Reward. Another benefit that medical technology start-ups can derive from an angel investor is the angel's willingness to go where VCs fear to tread. Angels will contribute capital to businesses early in the start-up cycle (when a prototype is being developed and the initial business and marketing plans are being refined), and sometimes even at the seed stage (when a concept exists but there is no prototype or management team).
VCs, however, typically invest in later stages of a company's development, at a point when the company is a going concern and perhaps already selling a product or service. "On the whole, financing from angels usually precedes any financing from VCs," says S. Ramesh, president of Philosopher's Stone Solutions (Redondo Beach, CA), a high-tech incubator, and a member of the California-based Tech Coast Angels investing club. "A good angel can often pave the way to a subsequent infusion of VC funding."
Jonathan V. Nguyen, an associate at Angel Strategies, adds, "Because they invest at earlier stages, angels take on a much higher level of risk than VCs, who usually expect a return of ten times their investment. The angels in our network look for a hundredfold return on their investment to cover the risk that they assume, since it's typical that only one out of every ten deals ends up being successful."
Less Is More. Angels differ from traditional VCs in another significant way. Although both angels and VCs take on the high risk associated with early-stage, prepublic companies in exchange for the prospect of very high returns on their investments, angels are willing to provide funding for start-ups without asking for a large equity stake in the growing business. This has to do with the size of the investments. "Angels invest anywhere from $10,000 to more than $1 million per deal, but the median level of financial contribution falls between $50,000 and $100,000, so most angel rounds involve multiple angels investing together to fund a company with between $250,000 and $2 million," notes Ramesh.
Most VCs, on the other hand, typically will not make investments of less than $3 million–$5 million, says Sobieski. Accordingly, VCs will demand a much larger equity stake. Sobieski emphasizes that "taking less initially allows the entrepreneur to build the value of the company, which will result in considerable leverage when he wants to raise that $5 million round." Auerbach adds, "Some VC firms are increasingly recognizing the value of seed-stage investing and are therefore financing smaller rounds at earlier stages, but this is still not in the vicinity of the relatively small amounts invested by angels."
A Value-Added Package. Finally, angels can also add nonmonetary value to a start-up. Unlike many other investors, they are likely to take an active interest in the operations of a venture, often drawing from their own business experience. "Angels are known for their hands-on approach and ability to mentor," says Ramesh. "Their willingness to take a more-active role in fostering the development of a start-up than a VC stems from the fact that angels are investing their own money. Since most VCs are constantly out scouting new deals, they don't have the time to follow up with how a venture is progressing in its day-to-day operations. This is why angels can often be so valuable to early-stage companies."
Brian Frenzel, a member of the Band of Angels and Tenex Medical Investors (San Mateo, CA), an investing group that focuses exclusively on medically related ventures, adds, "Because angels usually have considerable management experience, they can be a source of invaluable management advice, industry expertise, financing leads, and business contacts. They often make excellent board members or management advisors." In the medtech field, where technological proficiency specific to industry is vital to a company's growth, angels can therefore be a true godsend.
Angel Clubs
It seems that angels outnumber every other type of private investor these days. John Garcia, founding principal of Angel Strategies, believes that the number of angels in the United States has grown by a good margin since the Small Business Administration's count of 250,000 in 1999. It makes sense, then, that angel investors have organized their own communities, or angel clubs. These angel clubs are becoming increasingly common as angels continue to grow in number and influence. MX recently spoke with members of various angel clubs about how they function and what their investment criteria are.
The Band of Angels: The Grandfather of Angel Clubs. Founded in January 1995 by Hans Severiens and Fred Hoar, the Band of Angels, which specializes in financing technology start-ups, is the oldest and most prominent angel club in the Silicon Valley. According to Sobieski, the club currently has 150 members, and has funded 125 early-stage companies for a total of $100 million since its inception.
Of the companies funded by the Band of Angels, five have gone public, including Neoforma.com (San Jose) and Cepheid (Sunnyvale, CA), and a number of others have achieved liquidity through merger or sale. Though the Band of Angels focuses its investment attention mainly on the tech sector, Sobieski reports that it currently has 15% of its portfolio devoted to medical technology companies.
The Band of Angels prides itself on its members, some of whom are the most prominent businessmen in the technology sector. "The only difference among angel clubs, really, is who their members are," says Sobieski. The Band of Angels enforces its stringent membership criteria, seeking members who not only are able to make substantial investments, but who also have top-level executive or entrepreneurial experience and want to take an active role in screening deals for the club.
We know what entrepreneurs of medical technology companies need most: money. The fact is that no matter how stellar the idea a medtech entrepreneur conceives, without sufficient capital to get that idea off the ground, it remains just that—an idea. Although the majority of funding for entrepreneurial start-ups comes from personal savings, family, and friends, the types of funding available to entrepreneurs of medtech companies have increased in number and complexity in recent years.1 These sources include venture capital funds, microlending, credit, brokerage houses, and private equity.
By definition, the VC is a professional investor, while the angel is an amateur.
In contrast to its membership criteria, the Band of Angels keeps its investment criteria informal, holding monthly dinner meetings during which three companies are asked to present for 20 minutes each. "It is, after all, up to the individual angel to invest, so we don't like to have mandatory investment protocols," explains Sobieski. "We don't pool our money and invest as a group. The point of having an angel club is to leverage our expertise in order to source and research deals. Ultimately, however, we want the individual to make up his own mind." The presentations are followed by 20-minute question-and-answer sessions. Following the dinner, each company is invited to host a two-hour lunch where the entrepreneur is allowed to further explain the business strategy for any angels interested in pursuing the deal. Subsequent ad hoc meetings with members of the Band of Angels are required for proper due diligence before the company receives any funding.
The members, coordinated by Sobieski and Severiens, perform the bulk of the due diligence necessary to determine whether the company is fit to present to the club. "We don't accept any unsolicited submissions," he explains. "Every company that we hear from has to be sponsored by a member, so that cuts out a lot of the questionable material that we might otherwise receive."
In terms of investment criteria, Sobieski considers four things: the innovation of the technology that the company offers, the company's management, whether the company has intellectual property, and how passionate the entrepreneur is about the idea. "Of course, there are always other factors to take into consideration, depending on which stage of company development we're dealing with," he notes. "But these are the basic investment criteria through which the Band of Angels evaluates potential deals."
When asked if he had any advice to give medical technology entrepreneurs seeking angel financing, Sobieski replied, "There really isn't much difference in assessing the potential value of a medical technology company as opposed to companies in other industries. What makes a company attractive to investors is the risk-to-reward ratio. In medtech and biotech companies, angels are highly attuned to regulatory affairs because they make for added risk. My advice is to be knowledgeable in fielding the questions that angels will throw out in regard to regulatory issues, since this area is what makes medtech companies seem less attractive than other investments. What the entrepreneur should do is emphasize to the angel that once those regulatory hurdles are overcome, they serve as technical barriers to the entry of competitors."
Tech Coast Angels (TCA): The "T" Really Stands for Teamwork. TCA is an angel club based in Southern California consisting of four local chapters: Los Angeles, Orange County, San Diego, and Santa Barbara. The club has more than 250 members who are typically ready to invest from $25,000 to $100,000 per deal. Each deal funded by TCA usually draws a $1 million investment, which is divided among 15 to 20 angels. TCA is not just a club, but a true angel investing network. According to S. Ramesh, who belongs to both the Los Angeles and Orange County chapters, "TCA members divide the work of due diligence equally among themselves, making sure that angels with the appropriate mix of industry experience head up the due diligance committee that decides whether the deal in question is appropriate for the club."
TCA's due diligence process is extensive. As Ramesh explains, it consists of five steps: "First comes the submission stage, in which companies post their proposals on the TCA Web site. What we're looking for at this stage is a one-to two-page executive summary that appeals to our members.
"After we review the proposals, it's time for the prescreening stage, where a committee of four to five members decides whether the company has done its homework and is ready for stage three, the screening session. The screening session is where we gauge the interest level of our membership in the company. It's open to attendance by all of our members and consists of a 15-minute company presentation followed by a rigorous 15-minute question-and-answer period.
"After the screening session, if there is sufficient interest among the membership, a due diligence committee is formed whose responsibility is to identify all the problems of the company, resolving any issues that can be dealt with at this stage—all at no cost to the company. If the company makes it through this stage, the due diligence committee creates a term sheet according to which all TVA members will invest. It then moves to the final stage, which is a dinner presentation made to all the members. Checks are usually written within a few weeks after this dinner."
Sound exhaustive? It is, but TCA offers the companies it funds much more help than most other angel clubs. They not only provide the capital, but often find members to round out the management team and enlist angels with industry expertise specific to the company to join its board of directors, says Ramesh. "We do all this to safeguard our investments. Angels invest at stages where proper a management team and the right advisors are absolutely essential to a company's success."
As for TCA's investment criteria, Ramesh reports that there are five basic questions that need to be answered satisfactorily before TCA members will invest in a company—medtech or otherwise.
The first of these questions is, "What is the problem that your company addresses? I usually ask, 'How much pain is this solution alleviating?' In other words, I expect the entrepreneur to be able to define his market.
"I follow that up by asking whether the company's proposed solution to this problem follows a business model that's been proven. If so, how is it different from or better than other products already on the market?
"If the solution is not a proven one, then I ask the entrepreneur to demonstrate that there is a good chance that many people will change their ways and use his company's product. It's important for the entrepreneur to be realistic in this area, especially if it's a medical technology company, as the adoption rate in that industry is extremely slow."
The second criterion is how the company expects to make money. "The entrepreneur needs to be able to explain his company's money-making concept backwards and forwards," says Ramesh. "Also, when it comes to projections of how much money the company expects to generate, everyone knows that the numbers are wild guesses. We look for the financial statements to show that the entrepreneur knows his industry, knows how existing players make their money, knows how much they make, and has thought about his own cost and revenue model and how he will be profitable."
The third question that an entrepreneur seeking funding must address is the company's competition. As Ramesh explains, "I want to know as much as I can about the company's competitors. I'll usually ask a barrage of questions in this area. Who else has done similar things in the past? Who's your competition now? What's their market share? Who will be your competition three years from now? Ten years from now? Some entrepreneurs are clueless when it comes to their competition, and they really can't afford to be."
He continues, "Question number four has to do with sustainable competitive advantage. In other words, what are the barriers to entry? For medtech companies, the barriers to entry are usually based on the company's intellectual property and regulatory hurdles. The proper question to ask in this case would be, 'What have you done, or what do you intend to do, to protect your intellectual property?'"
The last investment criterion involves the liquidity of the investment. "Here's where we ask the company about what it sees as the planned exit strategy for investors in this round," explains Ramesh. "What does the company expect to accomplish with the funding we raise? How long before the company becomes profitable? And finally, what is the exit strategy—M&A, IPO, or being bought out by future rounds of investors?"
Ramesh explains that angels don't expect precise answers for all of these questions. "What we really need to know is whether the company has done its homework. For the amount of time that we invest in due diligence, it simply isn't worth dealing with companies that are unprepared."
Angel Strategies: The New Hybrid Angel. A for-profit corporation, Angel Strategies is truly a new breed of angel investing group—one that borders on being a VC fund. Founded in 1998 by John Garcia, Kurt English, and Jim Casparie, the company offers private individuals a much more structured way to participate in early-stage investing, thanks to its proprietary two-step funding mechanism.
"We provide the angels in our network with a standard process of due diligence," says Jonathan Nguyen. "Our approach minimizes the risk of investing early by pooling our resources and, at the same time, rewards those angels who assume the biggest risk by choosing to fund the deal in its earliest stages."
The approach, as English explains it, consists of two main stages: the Screen and the Scrub. "The Screen phase involves preliminary due diligence, while the Scrub phase is more in-depth," says English. "Our angels split up the cost of due diligence through a voting process that takes place before either phase is initiated. The angels who have contributed the most money to the pool set aside for a potential deal, of course, are given the greatest number of votes. However, the angels in our network are not obligated to fund any deal."
The process of determining which companies get funded works in the following way. "Once the company has pitched an idea that's been met with interest, that company is asked to visit our Technology Venture Alliance (TVA) Web site, which is an effective prescreening tool," explains Tom Zender, a principal of Angel Strategies. "TVA will then provide us with a report as to whether the company is ready to be screened."
At this point, the angels who wish to fund the Screen phase, or the initial round of due diligence, vote to do so. Completion of the phase results in a screening report, which is issued to all the angels in the network. The next step is the Scrub phase, in which extensive due diligence is performed. "The Scrub report examines every aspect of the business and typically exceeds 80 pages in length," says Zender.
"Once Angel Strategies has decided to fund a company, we become something like a business accelerator, providing the company with everything it needs in addition to the capital, whether it's effective management or early customers," says John Garcia. "We can afford to make this level of commitment because of the due diligence we put in before investing in a deal."
Because two of its founders have backgrounds in healthcare, Angel Strategies has always been interested in funding medical technology companies. "I believe that there will be a reemergence of angel investing in favor of medtech companies in the next two to three years," says Garcia. "But this reemergence will come in the form of funding raised by medtech companies that have some IT component to them.
"One of the companies that we are in the process of funding, for example, is X10Net, which offers physicians a customizable toolbar that sits on their desktop and allows them immediate access to information critical to their daily operations without having to open programs or log onto medical informatics portals. We think that this company will be successful because it provides a small, effective change. That's what hurts a medtech company's chances of getting funding the most—the slow acceptance on the part of the physician. It's why medtech companies offering life-changing products or services—and there are quite a few of them—aren't likely candidates for angel funding."
Tenex Medical Investors: Angels for MDs. Medtech entrepreneurs might do best to pitch their ideas to a member of Tenex Medical Investors, since this group funds early-stage life sciences companies exclusively. Now this is highly niched investing. Tenex's core interests lie in pharmaceuticals, medical devices, diagnostics, and platform technologies such as genomics. The group hosts dinner meetings on a monthly basis during which two to four carefully screened companies are asked to present to 80–100 potential investors.
According to member Brian Frenzel, "A typical investment from Tenex is on the order of $1 million, though it can be as high as $2 million or $3 million. Often, this is part of a larger round of funding that may include other angels, VC firms, or corporate investors."
He continues, "Tenex investors expect that these funds will be used to achieve value-enhancing milestones. For a research-stage company, this may mean creating and patenting a new invention. For a company in the product development stage, it may mean completion of a product beta test. For a company in the marketing stage, it may mean completing a test market. In each case, the company's value should increase substantially as a result of achieving the milestone. When discussing the issue of the appropriate amount of money to raise, I often use the analogy of crossing the desert: one should be sure to take enough water to reach the next oasis."
Frenzel predicts a somewhat slower rate of angel investing this year as compared with the last few years, given the economic downturn. However, he does not think that there will be a decline in medtech investing. On the contrary, he says, "I believe that medical technology, relative to other sectors, will garner a higher share than in past years."
Frenzel himself remains bullish on the medical arena as a whole. He explains, "Medical technology continues to advance at an accelerating pace, and there are many areas of unmet need. Furthermore, technological advances often reduce the overall cost of healthcare, since they offer an alternative to high-cost services. The net effect of technological advance is often a better and less-costly outcome."
According to Frenzel, Tenex's overall investment criteria for medtech companies are to look for proprietary technologies deployed to develop products for large, underserved markets. "We are very careful in screening our investments because the technical risk involved with medical technology products is often higher than in other industries," he says. "In a high-tech or software product, the investor can be confident that, given enough time and money, a product meeting the design specifications can be developed. This is not always the case in biomedical development—a great idea may simply not work or may run into unexpected adverse patient outcomes."
Conclusion
Angels are often the best bet for medtech start-ups in search of funding—that is, if your company isn't looking to market life-changing products that have yet to be soundly proven. According to Paul Auerbach of Garage.com, "Most angels are looking for a personally rewarding investment experience. In order to achieve that end, they need to understand what they're investing in. This can make medtech investing precarious for uninformed individuals, so that knowledgeable angels and life sciences–focused VCs are the best bet for medtech entrepreneurs."
He concludes, "The best way for medtech entrepreneurs to win potential investors, be they angels or VCs, is to clearly and concisely explain the uniqueness of their company's product or technology, regulatory and reimbursement requirements, defensible intellectual property, and the competition. In short, entrepreneurs need to make a compelling case for their company's market. Proof of industrywide support, of course, is always a tremendous asset."
Medical technology entrepreneurs should, above all, be prepared when seeking funding. As Frenzel advises, "Before approaching an angel, medtech entrepreneurs should put together an executive summary of their business plan and develop a well-rehearsed 30-second elevator pitch. Both of these should state the overall business concept and objectives and highlight the major selling points of the company."
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Send Me an Angel: Ten Tips to Appeal to Angel Investors To increase their chances of getting funding, medtech entrepreneurs need to prepare seriously before approaching angel investors. Although angels do not treat the investment procedure as formally as venture capitalists, it makes sense not to scrimp on research. Here are a few things to consider before venturing out into the investment community. 1. Create a business plan that emphasizes your sustainable competitive advantage. Entrepreneurs must define the competitive landscape of their business and how their solutions have a clear competitive advantage over others in the market. Angels will want to know how you plan to overcome regulatory and reimbursement hurdles down the line and what you will do to make your product more cost-effective than existing products. 2. Provide proof of concept for your venture. A medtech company must possess a product or underlying technology that introduces a new capability to the market or is more cost-effective than existing products. The existence of a prototype or working model of your product can greatly increase your chances of attracting angels. In addition, a medtech entrepreneur who can demonstrate the ability to create paying customers in the real world is far ahead of one who simply has a business plan and an idea. 3. Put together an effective management team. What qualifies as a strong management team for a public company does not necessarily apply to an early-stage venture. Early-stage companies will encounter problems and setbacks, and undergo growth and expansion stages. It is essential that management be capable of turning seemingly unsolvable problems into opportunities. 4. Accept that raising capital requires an expenditure of capital. It is unrealistic to assume that professionals will work on a back-end success fee, getting paid only when the company obtains funding, or that they will accept stock instead of cash. Professional advisors who might be providing you with consulting, legal, accounting, and investor introduction services require payment for their efforts and should not be assumed to be partners in your venture. 5. Identify and contact angels who are suitable for your company. Angels have various investment criteria, including deal size, company stage, and industry. A deal well matched with its prospective angels will have a higher probability of a successful closing. 6. Recognize that industry experience is valuable to angels. Unlike VCs, angels do not give much weight to whether you have been previously involved with successful start-ups or were a high-level corporate executive. However, they want to see that you understand the industry and that you've had some relevant experience. 7. Understand that raising capital takes time. According to John Garcia, founding principal of Angel Strategies LLC (Aliso Viejo, CA), it is not unusual for a medtech entrepreneur to spend 50–70% of his time raising capital from angels, a process that can last, on average, from three to six months. During that time, angels will ask numerous detailed questions as part of their due diligence process, and will raise objections in regard to your market, marketing strategy, technology, operations, or competitive landscape. 8. Recognize that angels are value-added investors. Most angels derive as much personal satisfaction from helping a new business owner as they do from contributing capital to the venture. Angels bring with them value-added benefits such as prior industry experience, valuable business knowledge, mentoring ability, and industry and business development contacts. 9. Never stop looking for additional angels until all checks from interested parties have cleared. Medtech entrepreneurs should work to gain the attention of three to four times the number of prospective investors that they need to raise adequate funding. Searching for additional prospective investors should never stop until all the required funding is in the bank. Otherwise, the entrepreneur will likely fall short of his capital-raising goals. 10. Invest your own money. Medtech entrepreneurs who expect investors to risk their money should also place a large percentage of their own net worth into their business. Those entrepreneurs who are not willing to assume such a risk are not considered serious businessmen by the investment community and will most likely not receive any funding. |
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Connections Looking for funding? For more information on angels who invest in medical technology companies, contact: | |
| Angel Capital Electronic Network http://www.ace-net.sr.unh.edu |
Angel Strategies LLC 949/215-9404 http://www.angelstrategies.com |
| The Band of Angels http://www.bandangels.com |
The Elevator 718/965-3568 http://www.theelevator.com |
| Garage.com 650/470-0950 http://www.garage.com |
Tech Coast Angels 949/859-8445 http://www.techcoastangels.org |
| Tenex Medical Investors http://www.tenexmedical.com |
UCSD Connect 858/534-6114 http://iweb.ucsd.edu/connect |
| Philosopher's Stone 310/316-3100 http://www.philstone.com |
Flora Nguyen is assistant editor of MX.
REFERENCES 1.1. ML Kourilsky and SR Carlson, "Entrepreneurship Education for Youth: A Curricular Perspective," in Entrepreneurship 2000, ed. DL Sexton and RW Smilor (Chicago: Upstart Publishing, 2000), 193–213.
Copyright ©2001 MX
