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So, you have a great idea. Now what? Ideas by themselves are worthless. Executing on ideas takes capital. How do you go about getting this?
Bootstrapping and Resourcefulness
Tina Seelig, Professor of Entrepreneurship at Stanford, wrote a book, What I Wish I Knew When I Was 20. In it, she describes an exercise she gives to her students. Student teams are given $5 and two hours to generate the best returns they can. Some of the students get the best results without even spending the $5. The point is, ingenuity and creativity can be worth more than money. Bootstrapping and resourcefulness is the foundation for the first and best fundraising.
When you are starting out, look for all of the low-cost/no-cost resources you can. For instance,
- Ask for help
- Call in favors
- Help others with their entrepreneurial projects
- Get help from local universities and incubators
- Bunk in at other companies extra space
- Look for equipment and furniture at sales and auctions
Thomas Edison once said, “The scope of thrift is limitless.” Fixed expenses are the enemy. Bootstrapping, working out of a garage or basement, and looking for every possible way to get results without spending money is the first and most important skill an entrepreneur can have, and a skill to keep using even and especially after you get funding.
Revenues: The Next Best Financing
Revenues have been the world’s favorite source of non-dilutive financing for over 6,000 years. When you start a business, build into the plan revenues that will at least cover your basic expenses. This will give you time, and as Rich Ferrari of DeNovo Ventures says, “If you have time, you have everything.”
What is the Anticipated Exit?
Many structures and exit opportunities exist for an entrepreneurial business. The most common is sale of the business to a strategic buyer. It is important that the business structure and goals are aligned with those of the investors. For example, a business that generates nice cash flow but will not scale up into a large company (a so-called “lifestyle business”) may attract the rare angel investor if structured as a loan paying an above-market interest rate. Investors seek a business that will scale, into which they can put a substantial amount of money to work, and are looking for returns of three to five times their investment in three to five years or better. An investor may occasionally consider a lower return, but this will come in exchange for a shorter investment term and less risk. A deal that can return ten times in a reasonable amount of time is attractive to anyone.
What are Investors Looking For?
Simply, the best risk-adjusted returns they can get for their money. They want to put money to work. They want the best technology opportunity and the best team to execute on it that they can get at the most attractive valuation. They are looking for a good horse (technology) and a good jockey (team) to ride it to the winner’s circle, at a valuation that allows them to make good money. It’s not just a good technology or a good team, it’s a good technology and a good team. In short, what investors are looking for are good investments!
Valuation
When fundraising, you’ll need to answer two key questions: what is the valuation of your company, and what percentage of it are you willing to sell?
Valuation is critical. Too low, and you sell too much of your company and give up too much control. Too high, and you set up unrealistic expectations for the next round of financing or exit (or the potential investor just walks away because the deal isn’t worth their while, or worse, they do not find you credible).
The other issue here is dilution. The more of the company that is sold, the less of a percentage stake the current owners will have. Dilution is unavoidable if you are raising money – you just want to be sure that raising the money will take you to a place where your smaller percentage stake is worth more than before. Steve Kam of Cogent Valuations offers the following:
- What is the expected time and method of anticipated liquidity for investors? (Include underlying assumptions that support projected revenues, earnings and cash flow.)
- Explain further with examples of comparable transactions, for the multiple of revenue, EBITDA (pre-tax earnings), or cash flow used to value the company for the current financing round.
- How will the proceeds from the current financing be used, and what will be produced in terms of operations, growth, revenues and cash flow?
Financing Terms
Money always comes with conditions.
Some of these are anti-dilution terms, liquidation preferences, participating preferred stock, board membership rights, cumulative dividends, option pools and others. Even if you get a valuation that you find acceptable, onerous terms can give you serious headaches down the road. If you get to the stage of getting a term sheet from an investor, you must have people on your team who have negotiated a venture financing in the past to avoid potential pitfalls.
Helpful resources include:
- Venture Beat
- National Venture Capital Association
- Brad Feld’s blog entry, Revisiting the Term Sheet: term sheet provisions defined
How Picky are Investors?
The process of raising venture funding can seem daunting. Be prepared to do a lot of networking and presentations.
Trevor, the following two items are like case studies. Please place them each inside of shaded boxes, one atop the other. I’ve tried to give a mock-up here.
Case Study #1: Intel Capital
Intel Capital, the VC arm of Intel Corporation, looks at hundreds of potential technology deals per year and will meet with about 100. These will be the result of a referral, never from a cold call. Out of 100 opportunities that they take the time to meet with, three will get funded, and all of these will have been told “no” at least once.
Case Study #2: Kyphon
Dr. Mark Riley and Karen D. Talmadge, Ph.D. were two of the founders of Kyphon, which was acquired by Medtronic in 2007 for $3.9 billion (a very successful exit in anybody’s book). In the early days, Dr. Riley and Karen were turned down by about every VC there was. They all thought that introducing the new therapeutic modality of kyphoplasty to spine was too risky, and no one had ever used balloons to displace bone before. It took exceptional patience and persistence to get the original funding for the company.
Moral of the story, fundraising for a medical device startup is a lot of hard work, and you will likely encounter a lot of rejection. For some startup CEO’s fundraising is their main job. You have to be able to connect with the right investors, tell a compelling story, show how the investors will make money, and be able to close the deal. Networking is crucial. No investor I can think of will seriously consider a business plan on a cold call. Getting an introduction is essential.
When presenting, remember this: The purpose of a meeting is to get the next meeting.
If you have 20 slides, and after ten slides a potential investor says, “This looks interesting; can I have my partners look at this?” Stop presenting, close your laptop and schedule the meeting.
The financing environment is very tough. A recent Wall Street Journal article from October 6, 2011, “VCs Take Their Case For FDA Reform To Capitol Hill,” reports:
- 36% of life sciences investors plan to increase investments in European startups, while 44% expect to steer more money to Asian companies.
- 40%+ said they would decrease investments in pharmaceutical and device companies, while about half said that they would increase investments in information technology and health care services.
- 61% of respondents said regulatory challenges were the top reason they were shying away from life sciences.
These challenges are due in part to the difficulties in getting new therapeutic devices approved in the U.S., and also the chilling effect of the impending medical device tax and comparative-effectiveness mandates.
Getting funding for life science startups is not impossible, but it is clearly more difficult than in years past. You can always heed the advice offered at the beginning of this article, bootstrapping and resourcefulness, is always the first and best kind of fundraising.
Types of Financing: A Deeper Look
4F Financing
“Friends, Family, Founders and Fools” often supply the very first type of money most startups get, usually in the form of loans. At this stage, a loan convertible later to stock may be the best vehicle, as setting a valuation at this early stage may not be possible or advisable. If the valuation is overly optimistic, disappointment is sure to follow if a later investor insists on a lower valuation. These are often informal deals; however, investors should meet the requirements of accredited investors (greater than $200,000 in annual income and over $1 million in net worth, excluding primary residence). Be cautious when raising money from family and friends. Will they still talk to you if you don’t hit your milestones and can’t pay the money back? Accepting investment money from Aunt Tillie’s retirement fund is probably a really bad idea.
Even at this stage, setting up a correct company structure is essential. It pays to engage advisors who have successfully done it before.
Government Grants
These can be a good alternative source of non-dilutive financing. Medical device entrepreneurs had taken a pass on these, as the process to get these funds can be lengthy. However, with venture financings taking so much longer or becoming less available, grants are looking more attractive. It may help to have an academic researcher on your team who is adept at grant-writing. Some of these are SBIR (Small Business Innovation and Research) and DARPA (Defense Advanced Research Projects Agency) if your technology has an important military application. With the dearth of early stage venture capital (VC) for medical device startups, grant funding is generating a great deal of interest, especially if you have some basic science to prove.
Angel Financing
Angels are taking up the slack in smaller financings that the VCs don’t seem to do anymore. Angels typically top out at $500,000, though some are doing deals up to $1.5 million and starting to syndicate like VCs. Angels are accredited investors (high net worth individuals) who typically individually invest $25,000 to $50,000 in a deal. Getting an angel deal done, involving ten to 20 investors, can require some “cat herding.” It may make sense to have them invest as a group under an LLC. Angels are less sensitive to market size than the ability for the investment to generate a decent return.
Angels may be surgeons who are enthusiastic about a technology, but it’s important to steer clear of conflict-of-interest regulations.
Venture Capital
There are tiers of VC firms, based on the size of their funds. Smaller boutique funds can do smaller rounds ($1 million to $3 million). Larger funds seek to put $10 million to $20 million to work in a round. VCs typically will not consider an opportunity with an available market less than $500 million to $1 billion or more. Typically, a VC funded company will have a group of VCs invested, so there is enough capital available to see the company through to exit. It is important to approach a VC that actually invests in your sector.
Venture Debt
This is a short-term loan to a startup that a bank will usually not make. Taking on venture debt bridges a short term need for cash to get to an important value-creation milestone, when selling equity is not available or desirable. The lender for venture debt counts on the ability of the investors to pay the loan rather than the assets of the business. Venture debt is usually not considered a first-line financing option. It is expensive money, and can be hazardous if your investors balk at putting up the money to repay the loan. In this case, the lender can end up owning your company.
Bank Financing
For a more mature company with assets and revenues, bank financing can help smooth out cash flow. Some companies will finance equipment with bank financing. It’s a good thing to have a strong allergy to debt. It can leverage and accelerate things on the way up, but can also sink you if things head down, especially if you fall out of compliance with your loan covenants, or if interest rates jump. You want to have a business that focuses on servicing your customers, not your debt.
Private Equity
Private equity (PE) funds typically will not invest in startups or companies without meaningful earnings. PE funds are usually interested in an undervalued company that can be purchased, sometimes with a leveraged buy-out using the free cash flow of the company, for a later resale of the company at a higher price after restructuring.
Strategic Investment
Some companies will invest in a technology that they want to have in their portfolio and do not want to develop in-house. The majors are starting to take up some of the slack due to lack of VC money. Success in raising this money comes from having something the company really wants, and from good relationships. Some companies have venture arms, and it can be valuable to reach out to them.
Ted Kucklick is co-Founder and CEO of Cannuflow Incorporated, San Jose, California, and the author of the best-selling title, The Medical Device R&D Handbook (2005 CRC Press/Taylor and Francis).
