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Venture capital alternatives for a healthcare business

Posted by: Amy Siegel on May 25, 2011 Source: S2N Health

A favorite rant of many med-tech entrepreneurs involves their disdain for venture capitalists. They wax poetically about not taking money from traditional venture funds. For some startups, it may be a chest-thumping expression of sour grapes, while others eventually cave and raise a VC round. Increasingly, though, emerging companies are making real on the threat and advance a long way with no or relatively little traditional venture dollars.

We have observed four trends that are conspiring to make it easier for companies to do the end-run around the VCs:

1. Super Angels Ascend

A popular VC alternative entails raising money from high net worth individuals, a.k.a. the “Super Angels” (Seems oxymoronic, doesn’t it? Angelic mega-rich folk.). The Super Angels are already taking over early stage tech investing in Silicon Valley, and are making their way into the Boston area. Many are flush with cash from successful med-tech companies that fueled that sector’s growth through the 1990s and 2000s, and are laying down some serious cash for promising startups.

The fine print on Angel funding: While the money often comes with fewer strings attached, trying to manage dozens of (sometimes quirky) investors can really burden a CEO. Prediction: As the angel dollars go up, some VC-like horns may sprout on those halos.

2. Incubators Grow Up

The earliest stage investors, those taking academic science and turning it into companies, are wondering why the VCs get to have all the fun (and multiples). Firms such as Pure Tech Ventures that reach in earlier than traditional investors, taking more risk for a piece of founders’ equity, are staying in longer to share in downstream valuation bumps and negotiate more equitable deals with the VCs. Eventually they might be able to cut the VCs out altogether.

Universities are also hoping to participate in more of the upside of companies sprouting from the work of their academic glitterati. Some are bulking up their own venture groups, while others are banding together to keep a hand in the game. Several institutions have invested in Osage University Partners to “exercise their pre-emptive rights” to participate in later rounds of financing, an oft-ignored clause in many university licensing agreements.

3. Private Equity Sneaks In

The past three years have seen more private equity firms, typically late stage investors, pouring money into promising startups. This model was first made popular by Digital Sky Technologies and their big money investment in Facebook, quickly followed by another in Zynga. This success story has led to an avalanche of copycats, with some traditional VC funds creating “late stage” funds and other private equity groups eyeing earlier deals. It remains to be seen whether this trend will sneak into the med-tech market and allow successful technologies to commercialize without going public or selling to strategics.

4. Joe Investor Steps Up

The last phenomena that could squeeze out traditional VCs in later financing rounds are Internet-based private equity clearinghouse firms such as SecondMarket. SecondMarket allows private individuals to trade shares of privately held companies that are looking to provide liquidity for their employees without going to the public market or VC investors. These firms are still in their infancy, but are seeing a quick rise in popularity -- not surprising given the Internet’s power to dis-intermediate everything (when’s the last time you talked to a travel agent?). The future for these alternative equity markets is uncertain, with threats of an SEC crackdown looming.

So how will the healthcare VCs defend their turf with all these competitors nipping at their heels? For starters, they will have to work harder to earn their place at the table, showing they have relevant domain expertise, can help deliver strategic partnerships, attract top management talent, and so on. While being squeezed themselves, VCs may need to squeeze management a bit less, maybe even administer some supportive hugs. With the sputtering economy, the uncertain regulatory climate and healthcare reform on the way, emerging med-tech companies feel squeezed enough already.

The author, Amy Siegel, is the co-founder of S2N Health, a consulting firm focused exclusively on providing business and marketing advisory services to emerging medical technology companies and their investors.

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