Medical Device & Diagnostic Industry MagazineMDDI Article IndexOriginally Published January 2000BOTTOM LINEUnderstanding the way venture capital funding works can help entrepreneurs attract the capital critical to a start-up's success.

January 1, 2000

10 Min Read
Funding a Medical Device Start-Up

Medical Device & Diagnostic Industry Magazine
MDDI Article Index

Originally Published January 2000

Understanding the way venture capital funding works can help entrepreneurs attract the capital critical to a start-up's success.

Editor's note: Looking for VC funding? Our list of VC sources highlights venture capital firms with a demonstrated interest in medical device technology.

Internet start-ups and medical device companies have something in common. They often begin the same way—with a great idea and venture funding.

For years, medical technology has been a fertile area for new companies. Many of today's leading medical device companies began as start-ups founded by industry professionals who took a risk. Valuation of these companies rose to millions—and even billions, in some cases—as the firms grew over the years. Nellcor, Acuson, Ventritex, Arthrocare, and AVE are just a few of the better-known examples.

Today's aging baby-boomer generation guarantees ongoing demand for innovative medical devices that improve therapies, reduce costs, or otherwise enhance the quality and economics of healthcare delivery. Opportunities abound for entrepreneurs who can come up with a sound business plan. The key elements that add value to a great idea are innovative approaches to solving problems followed by superior implementation in building a business.

ATTRACTING VC INTEREST

What attracts venture capitalists (VCs) to fund certain start-ups and entrepreneurs, and not others? In general, VCs look for three characteristics when analyzing a start-up's potential:

  • Sizable market opportunities.

  • Products and technologies that address unmet needs in innovative ways.

  • Management groups with deep experience, strong management skills, and the ability to build teams.

Entrepreneurs always start with what they hope is a great idea. From there, they build a company around it by developing not only products but also a sound business model. They research key questions about how the company will compete in the market, make money, and build value. The answers are then reduced to a plan that outlines the company's strategy for a VC.

Venture capitalists are professional investment managers who specialize in investing in new companies with high return potential. They raise money from institutional investors including pension-fund managers, charitable foundations, and wealthy individuals.

VCs collaborate with entrepreneurs to help develop their business model and build value in the business. They have a broad network of contacts for fund raising and recruiting, as well as substantial experience with start-up companies, and will typically invest over time in several rounds of a company's development.

But first, entrepreneurs have to attract a VC's interest in their company. There are a number of potential questions VCs will ask when they evaluate a company.

  • How big is the market opportunity? How large is the market for this product, and how compelling is the need? How fast will the market grow? Generally, potential market size must be at least $350 million to $500 million per year—and preferably more than $1 billion—to justify the returns VCs are seeking. Do many competitors with similar products or solutions already exist? Can the start-up be clearly differentiated? Does the start-up have an effective distribution strategy for its targeted customer group?

  • How original is the technology or product? Is the technology practically feasible? Does the entrepreneur have a prototype or other means to prove the concept? VCs generally look for a new product platform that makes a dramatic improvement over existing technology, not just additional features and benefits added to a current product category. Is the idea unique? Is it protected by a strong patent position to dissuade copycats and competition?

One frequent misunderstanding common among entrepreneurs is the notion that patents or the technology comprise the major value of the company, and that the work of bringing a product through development and adoption by customers is "just details." The reality is that technology by itself can't produce cash flow. The value of a company increases dramatically only if its innovative technology is developed into a viable long-term entity with multiple sources of ongoing revenue and a good reputation with customers.

  • How solid is the team? What is the experience and track record of key management team members? Because it reduces risk, VCs are especially attracted to a team that has individuals who have already "been there and done that" successfully in their specific roles at a previous company. Is the team complete? Early-stage companies needn't have all positions filled, but VCs like to see that the company can recruit strong candidates as the business progresses. VCs are especially interested in entrepreneurs who have a special advantage in a particular market sector because of their skill set or experience.

  • How realistic is the business model? How does the company plan to make money? Is the pricing and reimbursement strategy realistic? Are the margins high enough to support the research and development, clinical trials, and distribution costs associated with the device industry and still make an attractive return within an intermediate time frame? How will the company manufacture and distribute the product and support customers? How will the start-up compete with companies that have more resources?

HOW VC FUNDING WORKS

Once entrepreneurs have a sound business plan, they need to raise money to fund the company's activities. The most common way to finance a start-up is through selling equity, or stock, to investors such as VCs. (See sidebar, below, for other sources of funding.)

First, the entrepreneur must determine how much money to raise, and when to raise it. Entrepreneurs typically start out raising a small amount of money to prove the feasibility of the product idea, and then raise more over time (Figure 1).

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Figure 1. Start-up companies typically seek increasing amounts of funding as company value increases over time and the risk to investors is reduced.

To determine how much money to raise and when to raise it, entrepreneurs develop a road map of major milestones over the life of the company, along with a cumulative budget (Figure 2). They decide at which points in the company's development to raise funds—usually after major milestones have been completed. The budget determines how much the company needs at each juncture, and includes safety amounts in case unexpected delays or cost overruns occur.

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Figure 2. Entrepreneurs prepare a road map of key milestones over time to determine when to raise funds and how much they need. The above plan shows three rounds of funding prior to an initial public offering (IPO).

At the earliest stage, the company's worth is low, and the cost of raising money is expensive for the entrepreneur, because the company has not proven itself. As the company accomplishes its major milestones, it can raise progressively larger amounts of money to support hiring, production, marketing, and other value-building activities. Acquiring funding becomes less expensive to the start-up as more milestones are met and the risk is reduced for the investor.

Even if a VC is enthusiastic about a start-up, the structure of the investment must fit the VC's company profile or the firm will be unlikely to invest. VCs have specific criteria for their investments: some firms invest mostly at the early stage of a company's life, whereas others specialize in later-stage investing. Additional criteria can include the following:

  • The type of product—whether the focus is devices, biotech, diagnostics, etc.

  • The amount of money being sought.

  • The "premoney" valuation of the company.

  • The stage of company development.

  • The projected timing of the company's eventual liquidity and other financial issues.

OTHER FUNDING SOURCES

Venture capital is just one way in which medical device entrepreneurs raise money to start businesses, and different types of funding have distinct advantages and disadvantages. Some other funding avenues include:

  • Borrowing funds. The most traditional form of debt is a bank loan. Many entrepreneurs also use credit cards to finance their early work.

  • Angel investors. Certain wealthy individuals referred to as "angels" have funds set aside for high-risk investment. Industry gurus familiar with an entrepreneur's particular field can be helpful as investors, especially at the early stages when start-ups need only small amounts of funding. However, angels may not have personal time to help build the business, and they may not necessarily plan to invest over several rounds of financing.

  • Investment banks. For a fee derived as a portion of the money raised, investment banks can sometimes assemble a group of investors in what's called a "private placement."

  • Corporations. Corporate investors often add credibility to a start-up company; however, their agenda is usually to obtain distribution rights for the product or an inside track to acquiring the company if it is successful. Corporate investment can be a positive step toward the start-up's eventual liquidity, but can also discourage other potential buyers.

  • Customers. If the start-up's product solves a problem for a customer, the customer may feel motivated to help fund the company. This can create credibility in the marketplace, but may lead to competitive problems for the start-up when it tries to enlist additional customers.


 

STRUCTURING THE DEAL

If the start-up meets the VC's criteria and the VC is interested, the VC will conduct due diligence to find out more about the company and its prospects for success. During that process, the VC may request that the entrepreneur present the business plan and team to the entire partnership.

The VC will then make an offer to invest by presenting a term sheet. These terms include a specific proposal as to what the VC thinks the company is worth. This "premoney valuation" represents what the VC is willing to pay for equity in a competitive environment with other investors. Many factors figure into determining this number, among them:

  • Recent valuations of similar VC-funded companies.

  • The size of the potential market opportunity.

  • The completeness and quality of the start-up's management team, especially the CEO.

  • How much money is needed.

  • The projected valuation at the next round of funding and at liquidity, including data on financial multiples of other industry companies in formats such as price-to-earnings and market-capitalization-to-sales ratios.

The structure of the deal usually includes common stock owned by the founders, preferred stock that is sold to the investors, and an employee stock-option pool of common stock that will be issued to employees as part of their compensation packages.

Once the entrepreneur accepts the term sheet, legal documents complete the equity purchase upon the closing and transfer of cash to the company. Later in the company's life, there will likely be more rounds of financing, which may include additional investors.

CONCLUSION

The dynamic medical device industry thrives on new business ideas. Opportunity exists for innovative and committed entrepreneurs who wish to start their own companies. Once potential start-ups have developed a compelling business plan, investment dollars are sure to be available for those entrepreneurs who follow the right steps to secure funding. As many device industry professionals have found, starting and growing a company is a time-consuming and difficult process, but it can be tremendously gratifying in both personal satisfaction and financial rewards.

Leslie Bottorff is a partner at Onset Ventures (Menlo Park, CA), where she specializes in funding medical device and e-Health enterprises. Prior to joining Onset, Bottorff was a sales and marketing management executive in the medical device industry, working in both large companies and start-ups including Nellcor, Menlo Care, Ventritex, Medtronic, and General Electric Medical Systems.


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