Healthcare IT from the Investor’s Chair 9/28/10

Capitalizing a New Venture: So Many Choices…

I appreciate everyone who reads, especially those who leave comments. A comment on my previous post asked, “Isn’t it ALL about the patient?” 

As I pointed out in my response, for better or worse, healthcare in America is all about entrepreneurship — from medical spas to physician-owned hospitals and imaging centers to million-dollar salaries for hospital execs (I agree wholeheartedly with Mr. H on that topic, btw) to software entrepreneurs like Neal Patterson (Cerner), Judy Faulkner (Epic), or Randy Lipps (who realized that supply storage could be improved while his child was in the hospital and so founded Omnicell).

Anyone in the healthcare system, from physicians to business people to lab managers, who realizes that the current system they are using or experiencing just isn’t working as well as it could or should can decide to take the risk and form a company, develop a product, and go to market. Even before ARRA, HCIT attracted more than its fair share of entrepreneurs. That’s what makes this sector my favorite playground.

That said, I think it’s more like the playground of my youth. Before safety was the law and springy floors and safety teeter-totters came into being, it has historically been an area where start-ups thrive, but a disproportionate amount of investment dollars have been lost. Never a dull moment.

Hopefully someone reading this has started or is thinking of starting a new venture. Let’s explore their options along the continuum to finance it.

Friends and Family

Just what it sounds like. It’s going to Mom and Dad, Rich Aunt Joan, Crazy Cousin Bill, your stoner college roommate who was employee #55 at Google, and all the other friends you ask to put money into your new venture.

This is clearly a mixed bag. While their terms will likely be the most generous and they’ll likely value your new venture at the level you think is fair, these shareholders can be demanding in a psychic way. Family gatherings could turn into business updates. You’ll get calls on nights and weekends.

There’s the risk of that feeling in the pit of your stomach that if it goes wrong, you’ll have to face these people for the rest of your life. Hmm, sounds like a more expensive form of capital then I originally thought.

Angels

“Angel” typically refers to high net worth individuals who invest in private companies for themselves, as opposed to within a fund.

Angel investing has been on an upswing over the past few years for several reasons. First, with the stock market’s mixed performance over the past five years, this class of investor is looking to enhance their returns with some non-traditional investments. More importantly, angels are filling a gap that has resulted from the decreased popularity of traditional venture capital (discussed below).

Angels are typically much closer to the friends and family investor. They also have some of the same pros and cons.

On the positive side, they’re typically easier on valuation and they’ve often been entrepreneurs themselves. On the other hand, they’re not professional investors and so might lack some of the dispassionate views that a VC can bring. While they might have run companies, they might not know healthcare or software at all and might insist that their great success running a plumbing supply business obviously translates to your venture.

Their lack of a traditional venture fund (and its limited partners) cuts both ways as well. Where a VC might care only about an ultimate sale (or IPO), an angel might care more about receiving cash distributions. If you want to invest for growth, that could be a source of conflict.

If you have a choice of angel investors, as the knight in Indiana Jones and the Last Crusade said, “Choose wisely”. Do they bring experience and industry knowledge and contacts, or are they just a source of funds? Whichever it is, would they answer that question the same way that you would? How active do they want or plan to be? Will they want a board seat? Even if not, what will they require for ongoing communication as well as general care and feeding?

The importance of clarity and alignment of goals, vision, and timing here simply can’t be overstated. More than ever before, angels are starting to organize around their activities. Many top-tier business schools and tech associations have formed quasi-official angel groups.

Venture Capitalists

Traditional venture capitalists (VCs) are professionals at investing in private companies. Typically structured as a partnership, the investors (limited partners) tend to be foundations, pension funds, endowments and often high net worth individuals.

Research (and my observation) shows that VCs can bring much more than capital to their portfolio companies. They typically have strong networks in the sector and a great ability for pattern recognition, often having seen similar companies grapple with similar issues.

One of the most successful HCIT entrepreneurs I know once told me that, after herself, she attributed her company’s success most to the VC involved. This clearly suggests that valuation (and even terms) shouldn’t necessarily be the key factor in selecting one’s financial partner.

Beyond that, however, I’ve observed a huge continuum of both personalities and skills. I’ve seen VCs add tremendous value and insight. I’ve also seen VCs where I’d suggest the entrepreneur sell a kidney on eBay before taking their money.

Another factor to consider is that different funds tend to invest at different stages of a company’s life cycle. Loosely defined, these stages range from: (a) a good idea and founder (Seed Stage); (b) great team and product (Series A); (c) proven product and critical mass of customers (Series B); and business seems to be working, but needs growth capital (Series C and beyond).

While topnotch venture capital funds are continuing to fund early stage companies (and HCIT is no exception), for multiple reasons (to be discussed in a future post), fundraising has become more of a challenge to earlier stage companies than ever before. Hence the significant growth in angel investors to fill the gap.

None of the Above

What other options might exist for funding early stage ventures? I’ve seen companies of all stages think creatively to help bridge funding gaps. Government grants (especially lately) are a source of capital. Sourcing expertise from academia can help reduce the burn (many business schools and engineering schools have programs for students to consult).

One of my favorites is customer or partner financing. Perhaps a distribution partner or a few customers will pre-purchase software licenses, allowing you to combine a revenue and capital event. This win-win scenario serves to both build a customer reference and development partner and help your balance sheet.

Many hospital systems now have internal venture funds as well. These range in terms of stage of company they invest in (some are more risk-averse than others), but can also provide an appealing imprimatur to the marketplace of both customers and ultimate investors.

As I said, even though I don’t guard the Grail, my best advice here is to choose wisely. From my research days to now, when I’m looking at a company, one of the first things I do is see how they’re capitalized and who their investors are. Whether it’s shallowness or just a lesson learned, I find that it can tell me a great deal about a company. Is this a fund with a reputation for thoughtful investing and management, or an investor that typically throws companies to the public before they’re ready to maximize their own returns? Are there angels involved with experience and reputations for success?

While perhaps not the best way, assessing the backers is sometimes an efficient way of coming up with preliminary judgments about companies and their management teams.

Thanks for reading, but I’m afraid I’ve run out of space before even getting to Private and Growth Equity investors (who are sometimes also known as leveraged buy-out investors). While I touched on this in my Take Private post, it probably warrants its own, so let me know if there’s interest.

In the mean time, I’ll be attending the Health 2.0 Conference in San Francisco. That will be the topic of next month’s Investing Chair post. If you’ll be there and would like to chat, drop me a note.

Ben Rooks spent ten years as a sell-side equity analyst covering HCIT and related sectors before spending six years as an investment banker where he closed transactions ranging from $40 to 365 million. Seeking to make an honest living, he then founded ST Advisors, LLC where he works with healthcare companies and their sponsors, most often on issues around strategy, financing, and outcomes/exit planning. After all this time, he still can’t wait for HIMSS!