Working with Startups: Assessing Viability
By Michael Burke
In a previous article about accelerators and incubators, I made an argument for why it can be advantageous for purchasers of healthcare IT solutions to strike up vendor relationships with emerging startups. A drawback, however, is that more startups fail than survive.
In this article, we’ll take a closer look at the prospect of long-term viability for startups. To make it mildly entertaining (and to pay homage to Mr. H’s eclectic musical interests), we’ll compare it to a band trying to make it big in the music business.
What Are The Odds?
The stats related to long-term viability for a startup are not great. The rule of thumb popularized by the National Venture Capital Association is that 25 to 30 percent of venture-backed businesses fail.
However, this stat may be misleading and a little self-serving. Research from Shikhar Ghosh of HBS says that 75 percent of venture-funded enterprises never return cash to their investors, while 30 to 40 percent of them liquidate assets such that investors lose all their money.
The stats for a band trying to make it big are similarly grim. In 2009, only 2.1 percent of the albums released sold more than 5,000 copies. Of the lucky few bands that sold 5,000 or more albums, most didn’t make any money. The reasons most bands don’t make money are oddly similar to the reasons most venture-funded startups fail.
Winning the Lottery
When a band signs a deal with a major label, they feel like they won the lottery and that their success is guaranteed. They often get a big advance. However, they use a lot of that advance for recording the album and paying professional fees to lawyers and managers.
When the record is released, they may get lucky and sell a bunch of albums, but there are huge “recoupable” costs for video production, tour support, radio promotion, and other odds and ends. Even after selling a million records, they could still end up owing the label money.
When a startup signs a deal with a venture capital company, they feel like they, too won the lottery and that their success is guaranteed. They get a big cash injection (think “advance”). However, the cash doesn’t go in the shareholders’ pockets — it is used to fund and grow the business (just like a band uses the record company money for recording, promoting, and touring).
If the company gets lucky and folks start buying their product, things are looking good for the founders, right? Maybe. Maybe not.
When the startup signed the deal with the VC, it probably included a number of terms that are immensely preferential to the VC. The deal probably included terms that allowed the VC to exert considerable influence (if not outright control) over key decisions. The deal probably included “participating preferred” shares that allow the VC to recoup all their money (sometimes several times their original contribution) before the founders get a dime.
This means that in order for the founders to earn any money, they have to be able to sell the company for quite a bit more than they may have originally expected just to pay the “recoupable costs” (like in our band example). They are clearly motivated to swing for the fences. Because they gave up control, they can’t choose to focus on organic growth or on operating a great business. Instead, they have to go for the grand slam exit strategy.
For better or worse, raising venture capital moves the goal line for an exit, both in terms of time and value. It changes the responsibilities and objectives of an operator / founder. They must grow bigger and faster, with everything that approach includes. This may require a completely different skill set than the existing team can offer.
If you are a music fan, you may have heard of a number of bands going a different route lately. Instead of working with a major label, they release records on their own or work with a smaller label. They may not gross as much, but they’re far more likely to have a higher net. Possibly more importantly, they get to control their own destiny. Similarly, a startup may choose to bootstrap the endeavor on their own or they might take smaller investments from friends, family, or angel investors. This is the path we’ve taken with Clockwise.MD.
Either path is valid. It really depends on the goals and the circumstances.
What Really Matters for Customers
Based on what we’ve learned about the risks of working with a startup, what should purchasers of health IT do? That depends.
A health system that has its own early stage fund ostensibly knows the risks and probably doesn’t expect all of its portfolio companies to succeed. Even without a captive fund, most health systems can control the environment to some degree by leveraging their network to boost the success of the startup through referrals. The basic goal should be to avoid the 30 to 40 percent of startups that end up liquidating assets.
If they’re simply trying to solve a problem with technology and are considering a startup’s offering as a possible solution, they can mitigate risk through some simple reflection and investigation:
- Do they want to influence or control the feature set of the product? If so, they should jump in early. Companies often work hardest to serve their early adopters. Those adopters can have great influence in product development and pricing, which can serve everyone well over the long term.
- Does the startup have traction? Has it achieved critical mass in the marketplace? Sometimes a startup has a compelling solution but lacks market traction or reference sites to get the customer comfortable with investing time and money. In this case, vendors can enter into a beta agreement to gain the opportunity to prove their value. This can de-risk the relationship.
- How is the startup funded? What does its financial picture look like? Don’t be afraid to ask. Venture capital support certainly may not hurt a startup’s viability, but it should not be a requirement.
- Talk with current customers to get an idea of how well the solution works and the level of support and flexibility at the company. For vendors, reference sites are worth their weight in gold.
Working with a startup doesn’t have to be a nail-biting adventure. It largely depends on understanding clearly what you hope to accomplish and doing your due diligence.
I’ll close with a quote from Mark Zuckerberg, founder of Facebook:
"The biggest risk is not taking any risk. In a world that’s changing really quickly, the only strategy that is guaranteed to fail is not taking risks."
Michael Burke is an Atlanta-based healthcare technology entrepreneur. He previously founded Dialog Medical and formed Lightshed Health (which offers Clockwise.MD) in September 2012.