Originally Published September 1999
FINANCE
Making the Cut
How to get venture capitalists to show you the money, not the door.
Stacey L. Bell
So, your company has a great idea for a new medical device that would make a current surgical procedure less invasive, thereby shaving more than two weeks off patients' recovery time. Your R&D department has created a prototype, you've done some initial clinical testing, and you've assembled a crackerjack team to get the product off the ground. All you need now is the capital to support that team, right? Well, maybe. Before you take the leap into full-scale development, now would be a good time to make sure that your fledgling product has what it takes to win a venture capitalist's heart—and checkbook.
"There's been a major increase in venture capital financing over the past couple of years, but there's not as much enthusiasm for investing in the medical industry as in Internet or telecommunications companies," says Mark Heesen, director of legislative, regulatory, and entrepreneurial affairs for the National Venture Capital Association (NVCA; Arlington, VA). More than half of NVCA's 300 member companies—which comprise about 80% of the venture capital under management—invest in medical device start-ups. "Medical device and biotechnology funding has been much more stagnant. Those sectors just haven't had the returns investors are looking for."
"More than 2000 medical and other health-related companies apply for funding each year," adds NVCA's director of research John Taylor. "But fewer than 5% of those companies actually win funding."
What can you do to increase your odds?
The VC Checklist
Venture capitalists (VCs) say several factors are crucial in determining whether a company would appear to be a solid investment.A Strong Management Team. One of the most important predictors of future success is how well the current company is being run. "Venture capitalists try to determine whether the current CEO could lead a company with 500 people as well as he or she can lead a company with four or five employees, because these companies can grow so quickly," says Heesen.
"A good management team includes 'been there, done that' people who have held similar jobs in analogous companies," says Brian Dovey, general partner of Domain Associates (Princeton, NJ). "This is not a situation for on-the-job training." A solid management team should include experts in engineering, manufacturing, finance, operations, distribution, and marketing. However, VCs do understand that entrepreneurs may not be able to assemble all of these people themselves, so they often will find additional managers for the company if they decide to provide funding.
"Innovators tend to put together more-technical teams," says John Clarke, managing general partner of Cardinal Health Partners (Princeton, NJ). "It's essential that entrepreneurs have credibility in their area—that they know the thought leaders at university medical centers and have a strong technical network in place. Why should they have a management team from central casting lined up? That's not their milieu. But they should know that so-and-so at Johnson & Johnson might be interested in working on this project. The first few years you're managing product development and clinical trials anyway, so technical knowledge may suffice. Once you've accomplished the technological and regulatory goals, that's when you need the marketing and business leadership. Of course, if you don't have these people signed on to begin with, that raises the bar—your technology has to be that much more compelling so that I can go out and recruit a blue-chip CEO to come in and run the business side."
Even more important than the assembled team is the quality of the entrepreneur. "The team manager must be unique—able to do what no one else could do as well," says Clarke. Further, he or she must be able to cede control of the company. "It's rare to find a creative mind that is also a business mind," adds Heesen. "Entrepreneurs who aren't willing to give up some significant amounts of ownership in their companies will have a hard time finding investors."
Major Milestones on the Pathway to ProfitabilityVenture capitalists tend to provide enough funding at each round of financing to take a company to the next milestone. The four major milestones on a medical device company's pathway to profitability, according to Tom McConnell, general partner of New Enterprise Associates (Menlo Park, CA): 1. The product is physically created, and preclinical testing has been completed. 2. FDA submission has been made. 3. The product has been approved by FDA and is ready for market launch.
4. Revenue has been generated, and profitability is in sight.
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A Breakthrough Idea. Forget searching for VC funding if you've simply created a me-too device. "We are looking to invest in breakthrough products that fill a great unmet clinical need rather than in incremental improvements to existing technologies," says Dovey. That device also should reduce the cost of care, says Tom McConnell, general partner of New Enterprise Associates (Menlo Park, CA). "Products should meet a need that represents a large cost to the healthcare system."
A Great Market Opportunity. Entrepreneurs who hope for VC firms to help finance their dreams must also first qualify and quantify potential sales. It's important that revenue potential exceed $100 million and that the company can reach customers through either a small direct sales force or established channels, says McConnell.
An Unfair Advantage. "The number-one thing I look for a company to answer is, 'What is your unfair advantage? Why is it that only your company can create and produce this product?'" says Dovey. "We don't want a megacompany to say, 'Thanks for being a beta site; now we'll take over.' I need to know what is your advantage over an existing, established entity."
A Good Business Plan. "The worst thing you can do is simply send out numbered copies of a business plan marked 'highly confidential'," says Dovey. "Business plans are great, but only when they're used as a tool after an introduction."
What do VCs want to see in a plan? "I need to see a business model that makes sense in today's environment," says McConnell. "How will you get to a break-even point in a reasonable amount of time?" Most VC firms are looking for opportunities that will present a high rate of return within five to seven years.
The plan should detail—in an executive summary of three or fewer pages—the product technology and market potential, the members of the management team and their credentials, how much financing is being sought and why, major milestones in the company's history, and what the company's current financial status is.
Clarke also recommends the use of analogies: "Tell me that this product will do for your market sector what Intel did for microprocessors or what Johnson & Johnson did for rotable sutures, so I can get a real grasp on potential revenues and market opportunities. Just be sure your numbers are on target. Develop realistic expectations about how much money you need and how much time will be required to reach certain milestones by looking at successful companies that have been in similar situations."
Patent Protection. Of course, VCs do want to be assured that the company owns all intellectual rights to the technology or product. "But we're not as fanatical about having a clear, hard, fast patent on medical devices as we are on pharmaceuticals," says Dovey. "We understand that sometimes you need to be able to move quickly and efficiently."
Cause for Applause
"Getting that first round of funding means everything," says Dovey. "Once you've gotten that, the venture capital firm has a commitment to the product or idea as well as a vested interest in its success."
Ironically, it can be easier to score several million dollars than, say, $750,000. "You know, $750,000 doesn't buy enough time to develop a technologically ready product and manufacturing process for most companies," says Clarke. "If you're producing an implantable cardiac device, FDA will require many more clinical trials and more processing than it would for a surgical tool. But even a surgical tool needs enough funding in the initial round to last 18 to 24 months and take it to that first milestone—where you have an actual product and a core organization developed. You're unlikely to be able to do that with less than $2 million to $3 million—and even that's on the cheap. You can't jump over a canyon in two steps—$750,000 won't get you far."
Damon Pham, manager of information analysis for VentureOne Corp. (San Francisco), says, "Typically, early-round financing is fairly small—between $1 million and $3 million. If the company has a working prototype rather than just an idea on paper, it allows investors to better gauge the viability of the product, and as a result, may allow the company to raise a larger amount. Unless the company can distinguish itself from others in the field or is significantly advanced in its product development, it may need to seek other financing alternatives before approaching venture capitalists. Once the company is on the threshold of winning FDA approval or beginning clinical trials, the monies available increase dramatically."
"There are more pools of money available to you as you move along the continuum of reduced risk in later rounds of financing," says Clarke. "The technology and regulatory risks should disappear after the first round. Once you have your patents, FDA has approved the clinicals, and doctors have accepted the clinicals, you're ready to make real money, and most risks are reduced."
Most companies can expect to go through three to five rounds of financing before being acquired or undergoing an initial public offering.
More than Money
For start-ups, venture capital firms can offer more than just funding. Once they've invested in your idea, VCs can provide strategic management and growth guidance as well as attract additional capital, managers, and resources. "When you're seeking funding, look for a firm that's located in close proximity to your company so it can provide hands-on business instruction," recommends McConnell.
| The Real Deal | |||||
| For the past few years the medical device sector has seen an increase in both the number of companies receiving funding and the amount of average awards. Sources: Venture Economics (Newark, NJ) and the National Venture Capital Association (Arlington, VA). | |||||
| First-Round Funding | |||||
| YEAR | 1994 | 1995 | 1996 | 1997 | 1998 |
| Number of companies funded | 35 | 33 | 64 | 83 | 75 |
| Total funds awarded ($ millions) | 290.78 | 99.92 | 161.30 | 235.07 | 238.02 |
| Average deal ($ millions) | 8.31 | 3.03 | 2.52 | 2.83 | 3.17 |
| New and Repeat VC Funding | |||||
| YEAR | 1994 | 1995 | 1996 | 1997 | 1998 |
| Number of companies funded | 125 | 123 | 162 | 182 | 190 |
| Total funds awarded ($ millions) | 681.54 | 507.00 | 548.98 | 809.90 | 1040.99 |
| Average deal ($ millions) | 5.45 | 4.12 | 3.39 | 4.45 | 5.48 |
VCs tend to offer business guidance rather than operational assistance. "We get involved, but only at the board level," says Dovey. "Operationally, the entrepreneur runs the show. We help shape the company and its strategy, and we can make the right introductions. At Domain Associates, for instance, we have contacts in Japan and throughout Europe so we can easily create strategic alliances."
Getting in the Door
What's the best way to get a venture capitalist to look at your business plan in the first place? Trips to Tahiti and expensive wines notwithstanding, an introduction from a credible third party often is the best way to be heard. "It's always helpful to hear from a lawyer or an accountant familiar with this kind of deal that your product meets our business criteria—that you're not a mad scientist," says Clarke.
Adds Dovey: "The intermediary must be credible, and he or she should be familiar enough with our company to say, 'This deal is just like . . . ' and list three other deals we've become involved in. It provides a basis for us to invest."
Finally, Clarke recommends that when you do score that first meeting, you pitch appropriately. "You'll get just one shot at a first listen. If you come across as being out of touch or misinformed, you won't be heard again."
ConnectionsFor more information on venture capital firms that invest in medical device companies, contact:
National Venture Capital Association
Kauffman Center for Entrepreneurial Leadership
Medical Device Link |
Stacey L. Bell is a contributing editor to Medical Device Executive Portfolio and a former editor of Medical Device & Diagnostic Industry.
