What Every Medtech Entrepreneur Should Know About VCs

You’re an entrepreneur. You’re developing a new medtech application that’s going to take over the world and make life better for thousands, maybe millions of people. You’re idea is great, you’ve had some seed funding, perhaps a little money from family and friends, maybe even some angel investors. But you need to invest more cash to make your vision a reality. You need cash to build your A-team, for product development, reimbursement strategy, clinical trials, regulatory approval and market launch. So what do you do?

Do you know people?
(Nicolas Cage, Family Man)

You go to venture capitalists, or VCs.

But you’ve heard so many stories about this gilded and fearsome breed. Other entrepreneurs you know lost their shirt, or worse still their company, once the VCs got involved. And if they don’t already know you, they will not even answer your calls or emails. How do you proceed?

VC is the most expensive form of funding most entrepreneurs will ever encounter. They want a piece of your business, and some serious protection to offset the risk of investing in your high-growth (you think), high-risk (they think) venture.

Over the last 10 years, I’ve worked with VCs on both sides of the table. Both working with entrepreneurs helping to get their companies funded, and with VCs doing due diligence on interesting opportunities that come along. This post is to dispel some of the myths that get built up and bandied around about VC. And to help you, the entrepreneur, think right about how to get your venture funded:

1. Do You Really Need VC (Yet)?

Needing substantial investment into your company doesn’t mean you only have the option of VC. You can think about other creative financing techniques, see 8 Insights from Medtech Entrepreneurs at BioTrinty, UK.  These include grant and loan funding and can be surprisingly effective. While such funding may not obviate the need for all future VC funding, it can delay such need and meanwhile you’re able to build incremental value so when you do go to VCs, you (a) are de-risked since you’re further along in product development, and (b) you can get a better deal and stronger valuation (for the same reason, you’re de-risked and further along).

You can also think about revenue opportunities: everything from side consulting (heresy to some folks – don’t shoot me), to early to market “low-hanging-fruit” type product sales while you build out the real value driver. You could even elect to raise smaller step-wise amounts of capital which enable you to hit interim milestones, all the while building value and further validating your product (VCs often have this as a condition anyway – investing in your company in tranches based on hitting successive milestones).

Anyway, assuming you’ve either exhausted these routes, or you really need substantial cash injections NOW to beat out your competition and turbo-charge your growth prospects, you proceed to your VC funding search. Bravo!

2. Dilution – or How to Lose Your Shirt

Dilution is when your equity stake as a founder or early investor is shrunk or “diluted” as new investors come in. Any form of fundraising (even a public company issuing ordinary shares in a rights issue) will lead to dilution for shareholders that don’t “follow-on”, or add to their stake. But when VCs are involved, the mechanics get a little more interesting (for them, at least).

Solid as sand?

VCs use instruments called preference shares. These can be structured in many ways, but in essence they involve the VC getting a preference on any return before you or other shareholders. For example, say a VC invests in your company and gets 50% of the equity (say $5 million invested, at a post-money valuation of $10 million). Say you then spend a few years, realize your vision, and build and sell the company for $100 million; you get 50:50 or $50 million each (assuming no further financings). Sounds simple, right? But hang on, somewhere buried in the term-sheet, the VCs shares are 2x liquidation preference shares, while yours are ordinary.What does this mean?

Sticking with our hypothetical exit, the company gets sold for $100 million. The VC invested $5 million, and with a 2x preference right takes out 2x their money before any pro-rata equity split (in its simplest form). So, they get 5×2 = $10 million. And then a 50% share of the remaining $90 million. The VC gets $55 million, you and other ordinaries get $45 million. But hang-on, weren’t you equal partners? Maybe it’s not so bad – after all you still get $45 million! Happy days.

But what if your technology isn’t quite so great, or an unexpected competitor comes along (it happens, you know). Say you sell for $20 million. Now, the VC gets $15 million ($10 million pref, and 50% of remaining $10 million). Not bad, a 3x return for the VC. But you only get $5 million. Hang on – isn’t that what your stake was worth at the VC funding? So, you put in all this extra work, make the VCs plenty ka-ching, and yet have no more to show for it yourself? Hmm.

And if you get sold for $10- $15 million, you walk away with best case $2.5 million (the VC gets $10 million plus half the balance). If you get sold for $10 million or less, you get nothing. What!? What about all those years, the blood, sweat and tears. What about the re-mortgaged family home?

So, if your company does really well, it’s all good and you walk away friends. For your next venture, the VCs have already given you their direct number – as a funding prospect, YOU are now de-risked. But what if it doesn’t go so well?

Another point around dilution. Since the VCs have the cash they get to call the shots. At a recent conference, an experienced VC said the golden rule is: “He who holds the gold makes the rules”. Fitting. So, while you may think your company is worth $5 million pre-money, the VCs may disagree and you settle at $3 million (after all, you need to get the cash in and build, right?). Now, you own 37.5% equity post financing, and the VC owns 62.5%. And the preference shares. See how that works on the exit values above?

3. What’s the VC Business Model?

At this point, it makes sense to think a little about what drives the above described VC behaviour. To an outsider, it may actually seem a bit tough, even mean. But when you look behind the curtain (as with all Wizards of Oz), you realise that VCs are just regular people like you and me, trying to make a living. I’d even go as far as saying many of the VCs I’ve worked with are thoroughly decent people.

As with many things in life, follow the money trail (or incentives), then understanding behaviour or actions gets a lot easier.

VCs are fund managers who invest in early(ish) stage, growth companies. Their investors are called Limited Partners, LPs (these can be pension funds, sovereign wealth funds and wealthy individuals, amongst others) and the VC manager is called the General Partner, GP. Fund-life is usually for around 10 years, with lock ups and potential 2 year extensions. The most common fee model is called 2 and 20. This means the GP charges the LPs 2% of assets under management, and 20% profit share on any realised gains.  So, if a GP manages a $100 million fund, this means $2 million in annual management fees, and 20% of any profit, or “carry”, on exits beyond the VC firms investment (by necessity this is a simplified description, variations include hurdles for performance, stages of a funds life having different management charges). If the VC firm manages $1 billion, the management fee for turning up to work is $20 million.

Think about that for a minute. As with most fund managers, the short to mid-term incentive (up to 10 years) is strongly geared towards assets under management. The more you manage, the bigger your fee. The difference can be $millions. And mid-way through a fund’s life, a VC starts thinking about raising the next fund. This is only going to come about if the first fund has been deemed to be successful for its LPs. Or else why would they, or other LPs invest in Fund II?

Think about THAT for a minute. When, as a VC, you’ve finally managed to raise your first fund, and you see the potential $millions from “2 and 20”, you do everything in your power to protect your LPs funds and grow them, so they invest in you again. Yet you’re investing in early-stage high risk technology ventures. So, you use preference shares. You position yourself to get the best valuation you can on each deal.

If you were a VC, wouldn’t you do the same thing? It’s your business and if you don’t protect and grow the funds, you end up with no business. As an entrepreneur this is something you already get. You’re in a maddeningly competitive and tough environment. You use every advantage you legally can to win your game and be the best. It’s human nature; it’s survival.

The really good VCs  totally get that putting the company and entrepreneur first is the best way to boost long-term fund returns. (These have usually been entrepreneurs or industry operatives themselves in past lives). But not everyone is so enlightened.

Like you and me, VCs are just people. As Nicolas Cage said in Family Man: “Business is business. Wall Street, Main Street. It’s all a bunch of people getting up in the morning, trying to figure out how they’re going to send their kids to college. It’s just people, and I know people.”

Do you know people? As an entrepreneur, all you really do is figure out what people need, work with other people, and find out a way to help them get it. Do you know people?

4. Knowledge is Power

Don’t complain. Life is tough. Especially for entrepreneurs. Don’t complain about how tough it is to get your company funded. Don’t complain about your term sheet (the offer from your VCs). And don’t complain if you ever lose your shirt.

Knowledge is power.

But do arm yourself with knowledge. Know your VC counterparty. You would do that in every other part of your business. You learn all the detail you need about assessing market opportunity and risk, about product detail, patent protection, clinical trials, regulatory approval, reimbursement, launching and selling your product. Or you make sure as heck you have people in your A-team that can help you with specific areas beyond your expertise. You don’t blindly sign agreements that you don’t understand.

Do the same when it comes to raising money, and working with VCs. Learn the details so you’re armed in a negotiation. Your prospective VCs will probably love you for it – it shows you’re prepared and continually learning your entrepreneurial art. It will give them more confidence that you will be a worthy steward of their investment.

And finally, Simon Acland, an ex-VC and now investor, describes the breed and how best to work with them in more detail in his book: Angels, Dragons and Vultures. Pure gold dust. Get the knowledge.

What do you think?

This post is by Raman Minhas. He is a medtech enthusiast, CEO of ATPBio, and works with entrepreneurial companies, providing support with partnering, financing and exit planning. He is also an investor in medtech stocks, using a value based approach.

Raman’s next conference attendance will be at a Medtech focused event – EuroMedtech in Grenoble, France. He will be moderating a panel: Keys to emerging company commercialization. Feel free to reach out if you’re going to be there.


4 thoughts on “What Every Medtech Entrepreneur Should Know About VCs

  1. Hi Raman,

    Nice piece – explains the “deal” with venture capital very nicely.

    Like you, I have been on both sides of the table and the only part I disagree with is your suggestion that the outcomes for a sub-optimal exit with a 2x preference is somehow “unfair” to the entrepreneur. I don’t think it is. If there is a stellar exit, the entrepreneur is in seventh heaven; if there is a mediocre exit the entrepreneur still gets a decent pay-out. You can’t possibly say that when gets £5million in cash that is “the same” as the notional £5m pre-money valuation when the VC investment went in! Cash has a way higher real value than the face value of an illiquid stock. And if there is a fire sale, the VC gets their money back and the entrepreneur gets nothing. All those outcomes look pretty fair to me.

    So all would be fine and dandy in a world where VCs stuck to 2x preferences. What the entrepreneur has to watch out for are higher multiples, compounding interest payments, rights to “put” capital prior to an exit and all sorts of more subtle ways of distorting the capital distribution in favour of the VC and against the founders and other ordinary shareholders.

    So don’t give a simple 2x liquidation preference a bad press. Thats the “good” end of the VC spectrum!

  2. Thanks, David, very good points. I agree that the 2x preference is the “good” end of the spectrum. Just used that example to illustrate the math. Also, you’re correct that $5 million pre-money valuation is not the same as $5 million cash. And I’m not suggesting any of this is unfair – just that it’s the real world and all entrepreneurs should be aware.

  3. Pingback: Corporate VCs v VC firms: Are they aligned? | Medtech Value Investor

  4. Pingback: Medtech entrepreneurs: What do investors want? | Medtech Value Investor

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