Funding Sources for Life Science Startups
Christina Hernandez Sherwood, eMed Editor, MedCity News
Bringing a healthcare drug or device to market requires an intense amount of capital. Federal regulation in the United States, Europe and beyond requires clinical testing and trials, as well as large sales staffs and other expenses. The early requirements for investing can force entrepreneurs to seek private, dilutive investing and rapidly cut into the amount of ownership of the company by the entrepreneur. To add to the problem, private investments in biotech and medical devices – particularly early stage – are beginning to shrink. Now more than ever, it is critical to leverage every possible way to raise capital for a healthcare product: from a drug or device to the emerging health IT and mobile health segments.
Definitions: Dilutive and Non Dilutive Capital
Dilutive capital is an investment that adds additional shares to your company, decreasing the amount previous owners hold in the business. In a simplified example: a company begins with 100,000 shares owned entirely by the entrepreneur. To raise additional money, the entrepreneur issues 50,000 new shares investors will buy. When those are sold, the company now has 150,000 shares: 100,000 owned by the entrepreneur and 50,000 by new investors. As a result, the entrepreneur has diluted his share in the company. The entrepreneur now owns two-thirds of the business.
Other issues around dilutive capital. There are other issues for entrepreneurs beyond pure shares in a company. Among them, investors could ask for seats on a board of directors or seek a preference in being paid once a company has been sold. There is also the value of the company at the time new shares are issued (valuation).
Non-dilutive capital is money an entrepreneur receives that does not affect the ownership of the company. For example, a loan or a grant may require interest or carry special requirements about how the money is used, but it will not impact the shares of the company. Investors will often find a company more attractive when they see an entrepreneur has explored and tapped into these alternatives.
Personal Investment (Bootstrapping)
Personal investment means sustaining a business without external help (also known as bootstrapping). Entrepreneurs need to have “skin in the game:" some kind of personal, financial investment that demonstrates faith in the business and shows future investors the belief an entrepreneur has in the business. Personal investment can come in at least two forms: up-front cash invested into a business by an entrepreneur, as well as deferring a salary or going without pay for a fixed period of time. Be careful how far to take this approach. Some consider the way investors discuss “skin in the game” as a “shylockian tactic” that if overdone will demotivate the founders of the company, according to the Fundable Entrepreneur.
Being an entrepreneur is stressful. This stress hits them and their families 7×24. One would think that an investor would not want to add to that stress by forcing them to get into hot water with their families. Asking for “Skin in the Game” creates undue stress on the one group of people you want to be relaxed and focused, not fending off phone calls from debt collectors, divorce attorneys and significant others.
Family and Friends
After an entrepreneur exhausts his own resources, the next step is often turning to friends and family (often called "friends, family and fools") — the most common source of startup funding, and the only one for many non-technology companies.. Life science startups often depend on close contacts for as much as $200,000, until they hit early validation points that can attract larger investors, says Mark Jensen, managing partner of Deloitte's Venture Capital group. The dollar amounts may be small, but depending on how one values his relationships, the stakes can be high. Venture capitalist Fred Wilson, author of the MBA Mondays blog, recommends only taking capital from family and friends who can afford to lose the investments. Most companies fail, so the risk of loss is real. These are the only investors you're likely to encounter who will be predisposed to saying yes, but you still owe them a clear and detailed presentation of the opportunity and risks. Once everyone is on the same page, Wilson suggests offering convertible notes with a discount and valuation cap around 10 percent of the business.
Tips When Approaching Friends or Family:
1. Be prepared. Set a meeting and show up with a practiced, organized presentation.
2. Communicate the risks. Be honest and upfront about the high risks involved.
3. Write down your agreement. Make sure it includes a repayment plan.
Incubators and Accelerators
There are approximately 1,250 business incubators in the United States, including about 120 with some life science focus, according to the National Business Incubation Association (NBIA). These programs vary greatly in their structure and services.
Often associated with universities or medical centers, life science incubators frequently offer affordable office space attached to shared wet lab facilities. Others focus on accelerating companies' progress by offering intensive coaching, networking and support services. Some programs include seed funding up to $250,000 at a stage when few others are willing to invest. “We love risky ideas; entrepreneurs that come to us don’t even have to have a product,” said Halle Tecco, CEO of Rock Health
In exchange for this early support, incubators often take an equity stake in the company. This can be a great value, but not all incubators are created equal. “There are a lot of incubators that are asking for a piece of the company and promising you advantages and not really delivering,” said John Steuart, managing director of Claremont Creek Ventures, an Oakland investment group. The NBIA recommends that entrepreneurs screen incubator programs based on their track record, graduation policy and staff qualifications.
Leading Life Science Incubators
San Jose BioCenter (San Jose, Calif.) A state-of-the-art facility with wet lab and office space for high-potential life science, nanotech and cleantech startups. Management targets companies with compelling technology (with IP assets pending or secured) that addresses significant market needs. Applications are screened by management, and if they pass the screen, the company is invited to an in-person interview. Decisions are made within one month of the in-person interview.
MU Life Science Business Incubator at Monsanto Place (Columbia, Mo.) This university-based incubator is open to ventures formed by Missouri faculty, staff or students, as well as entrepreneurs recruited to accelerate the development of a high-tech industry cluster in the region. Prospective tenant companies are evaluated based on their business plan and relationship with the University of Missouri. Business plans should include anticipated economic impacts for the region (new jobs, wealth creation, investment attracted).
BioSquare at Boston University Medical Center (Boston, Mass.) Located in the heart of Boston’s academic and medical community, this incubator promotes state-of-the-art, turnkey biomedical facilities, with amenities that include cold rooms, centrifuge, autoclave, glass washer, and freezer. Lengths of stay range from 6 months to 2 years.
Life Sciences Business Development Center (Augusta, Ga.) This biomedical science business incubator is managed by the Georgia Department of Economic Development and located on the Medical College of Georgia’s main campus. It has approximately 1,600 square feet of space and houses up to five entrepreneurial businesses. Each unit includes a wet lab, clean room or culture room and two offices. Shared spaces include autoclaves, a darkroom, a walk-in cold room, break room and conference rooms.
5. QB3 (San Francisco, Calif.) Founded in 2000, the California Institute for Quantitative Biosciences links more than 220 laboratories at UC Berkeley, UC Santa Cruz, and UCSF to support high-level basic research and training. Through commercialization, QB3 converts university research into products and services that can benefit society. It launched the first incubator at the University of California, the QB3 Garage, in 2006, and a similar effort at Berkeley in 2010.
6. Fogarty Institute for Innovation (Mountain View, Calif.) This educational nonprofit was founded by Dr. Thomas J. Fogarty in 2007. It offers three programs (Innovation/Cultivation, Clinical Research/Validation, and Outreach/Education) representing different aspects of medical technology innovation. With space on the campus of El Camino Hospital, the institute includes laboratory and engineering space for collaboration.
7. Healthbox (Boston, Chicago, and London) With locations in three major innovation hubs, Healthbox works to empower healthcare entrepreneurs and expose the industry to innovative solutions. The incubator works to identify high-potential healthcare technology startups and help them stimulate early-stage innovation. Through collaboration, Healthbox provides a platform for the industry to engage with innovators and learn from the entrepreneurial community.
8. Blueprint Health (New York City) Billed as "the largest network of mentors with healthcare expertise of any accelerator and co-working space," Blueprint Health pairs entrepreneurs with their peers and venture capitalists to foster introductions and advice. It offers an intensive three-month accelerator program to help entrepreneurs find customers and capital. Blueprint Health, which has 12,000 square feet, helps more than 100 healthcare companies each year.
Government and Foundation Grants
Government grants are a growing source of seed funding for life science startups. As venture funds pulled back in the wake of the financial crisis, the number of federal small business technology grants increased each year between 2008 and 2010. The primary sources are Small Business Innovation Research (SBIR) and Small Business Technology Transfer (SBTT). Both programs distribute awards in two or three phases. The first phase normally does not exceed $100,000 for one year. The second phase is typically no more than $750,000 for two years. SBIR applicants' primary employment must be with a small business. SBTT grants require a formal relationship between the company and a research university or nonprofit. Applications for SBIR/SBTT grants through the National Institutes of Health jumped from 4,529 in 2009 to 6,338 in 2010, causing success rates to slide from 24.5 percent to 17 percent — but the rates are still very high, and better than other funding sources.
Mark Jensen says SBIR/SBTT grants are a very good funding source for early stage life science startups. It is important to read the fine print. The grants sometimes require licensing arrangements, but companies frequently retain control of research data. “They understand the proprietary rights. They understand intellectual property and the importance to protect it. They're going to get their rights in the company, but they are not going to be an intrusive shareholder,” said Jensen. The biggest hazard with grants is making sure they do not distract the company from its commercial goals, says John Steuart of Claremont Creek Ventures. "Grants are best used if you would do the work anyway," Steuart said.
Foundations are another potential source for seed grants, especially for companies whose technology targets a specific disease. Relationships with patient-advocacy foundations can also result in access to experts and to patients for clinical trials. “It’s not just money. It’s access to talent, people, patients,” says Bob Beall, president and CEO of the Cystic Fibrosis Foundation, one of several foundations that offers research grants to companies. Trade shows are a good place to find and network with foundations that offer seed grants.
Examples of Foundations that Offer Research Grants
Accelerate Brain Cancer Cure
The Chordoma Foundation
Cystic Fibrosis Foundation
The Michael J. Fox Foundation
State and Regional Incentives
Entrepreneurs will also find a wide range of unique state and regional incentives, from tax credits to cash grants. Forty-two states have programs aimed at helping companies commercialize new technologies, some specifically targeting life science startups.
The state of Washington, for example, set aside $350 million from its tobacco settlement to fund a Life Science Discovery Fund, which allocates $35 million annually to research projects with economic development potential.
Several states over the past 15 years have also created tax credits to encourage the flow of venture capital to life science startups. One such program in Maryland offers a 50 percent tax credit for investments in qualified Maryland biotech companies, up to $50,000 for individuals and $250,000 for corporations or venture funds.
Several cities, counties and states have also helped establish business incubators, many of which are specifically aimed at life science companies. Examples include the Virginia Biosciences Commercialization Center, the North Carolina Biotechnology Center, and the New Orleans BioInnovation Center.
State and Regional Resources
Washington State Life Sciences Discovery Fund
CONNECT of San Diego
Texas Emerging Technology Fund
Pennsylvania Life Sciences Greenhouse Initiative
Georgia Research Alliance Eminent Scholars Program
Kentucky Department of Commercialization and Innovation
SC (South Carolina) Launch!
State and Regional Venture Funds/Credits
Michigan's 21st Century Jobs Fund
Maryland's Biotechnology Investment Tax Credit
Missouri's New Enterprise Creation Tax Credit
Kentucky Investment Fund Act
Oklahoma’s CAPCO Tax Credits Act
Maryland Biotechnology Center
Virginia Biosciences Commercialization Center
North Carolina Biotechnology Center
New Orleans BioInnovation Center
Kansas Bioscience Authority
Michigan Life Science and Innovation Center
Central Valley Business Incubator
Massachusetts Biomedical Initiatives
Long Island High-Technology Incubator
Rochester BioVenture Center
Angel investors are wealthy individuals who are often former entrepreneurs themselves. They've built successful companies and have money and advice to reinvest in promising new startups. Angel deals aren't tracked quarter-to-quarter as closely as venture deals, but a report from the Center for Venture Research at the University of New Hampshire estimated that in 2010 angels invested $20.1 billion in 61,900 startup businesses, a 14 percent increase in dollars compared to 2009. The most preferred investment per round was between $250,000 and $500,000, according to an Angel Capital Association survey. In exchange, angels expect to own between 20 percent and 40 percent of the company, and they want to see a return better than what they could get from a bank or stock portfolio, usually between 20 percent and 25 percent annually. Angels do not typically expect a board seat, although some angel groups will request one with larger investments.
Cold calling prospective angel investors is not recommended. Introduction through credible referrals will improve the odds of success. Ask lawyers, colleagues and accountants for contacts they might have. Follow local deals in the press and pay attention to who funded them. Network with companies that have recently received funding. A rule of thumb is that entrepreneurs should network for 6 to 18 months before pitching. “Angel investors in healthcare tend to be people who have been successful in healthcare,” says Mark Jensen, who recommends seeking out retired CEOs who will understand the technology. Always work with accredited investors. Non-accredited investors can trigger additional disclosure requirements and complicate acquisitions. They're also more likely to be hostile, says startup lawyer Ryan Roberts. Angels will evaluate companies based on management teams, the size of opportunity, and the product or service. Entrepreneurs want to evaluate angels and work with ones who can offer not only money but also advice and connections. “Try to get bigger checks from fewer people who are value added,” recommends John Steuart of Claremont Creek Ventures.
One key decision is whether the startup will offer an angel equity or convertible debt. Convertible debt has lower transaction costs and can benefit entrepreneurs if they expect the company's value to increase before the debt is converted. Debt takes priority to equity in liquidation, which may be appealing to investors, although with most failed startups there is little or no liquidation value.
Life Science Angel Groups
Life Science Angels
Mass Medical Angels
Salt Lake Life Science Angels
Health Tech Capital
North Coast Angel Fund
Twin Cities Angels
Triangle Angel Partners
Physician Investment Group
Ohio TechAngel Fund
Mid-Atlantic Angel Group
Tech Coast Angels
Golden Seeds LLC
Hyde Park Angels
Alliance of Angels
New York Angels
Venture capitalists are professional investors who manage large, high-growth funds, often for institutional investors such as pension funds, endowments and corporations. They specialize in helping to build and sell companies, either through IPOs or acquisitions. They offer large sums of money — beyond what most angel investors can provide. Venture capital showed signs of a rebound in 2011. U.S. venture capital funding for life science companies increased 21 percent in 2011, according to PricewaterhouseCoopers and the National Venture Capital Association. Venture funds poured $7.5 billion into 785 life science deals during the year. Life science companies have accounted for about a quarter of all venture deals in recent years.
Venture capitalists have shifted their focus in recent years toward later-stage companies. They generally don't want to invest unless they can put in at least $10 million. They look for companies that can produce rapid and high growth, and they're not particularly patient. They tend to expect returns of three to five times their investment within two to three years, or a return of 10 times their investment within three to seven years for early stage companies. Their cost can be steep. VCs generally want a 20 percent to 40 percent equity stake for each funding round. It can also be the beginning of the end of control for founders. Venture investments usually come with a board seat, and aggressive venture capitalists have been known to grab enough power to oust founders.
As with angels, introductions are key. Mark Jensen says too many entrepreneurs waste time with a “spray and pray” approach to distributing business plans. Focus on funds that have invested in life science companies. Venture capital isn't as geographically focused as angels tend to be, but location still matters. “You'll see that healthcare investing is pretty concentrated in a handful of states,” says Anand Sanwal, CEO and co-founder at CB Insights, a New York research firm that tracks dealmaking. “You may want to position yourselves in a place where those investors are.” California and Massachusetts accounted for 50 percent of healthcare deal share and 67 percent of dollars in the last quarter of 2011, according to CB Insights.
Another growing source of funding is corporate venture capital — funds owned by public companies, many of which have stockpiled cash during the recovery and now need a way to spend it. Corporate venture funds often look to fund companies with technologies they may want to license at some point.
For entrepreneurs interested in venture capital, it’s important to consider where they are in their investment cycle with regard to a particular fund. Venture capitalists might force a premature exit for the company in order to capture returns for their investors and attract more investment for their next fund. “Shorter holding periods could provide attractive IRRs for a fund despite lower target multiples,” Bruce Booth wrote in a piece for Forbes. That’s because the time-to-exit for their deals is shorter, he added, so a two-times gross fund might have a good IRR if it returns capital in less than five years, rather than less than 10.
Life Science Venture Capitalists
ARCH Venture Partners
Kleiner Perkins Caufield Byers
Polaris Venture Partners
Prospect Venture Partners
Psilos Group Managers
Third Rock Ventures
Thomas, McNerney & Partners
Three Arch Partners
Unlike traditional venture capital investors, strategic investors invest on behalf of their parent company. Examples include Time Warner Investments and Intel Capital. In 1994, just 2 percent of U.S. venture capital investments were made by these corporate venture capitalists. By 2000, corporate venture capital made up 17 percent (almost $20 billion) of venture investment, according to the Strategic Venture Association. Today, the percentage is likely even greater and it’s fair to say that most early- to mid-stage entrepreneurs who successfully raised money for their companies garnered at least some of that capital from strategics.
Despite assumptions that technology is the ideal sector for venture capital investments, venture investing in the life sciences actually outperformed venture investing in tech in the 2000s, according to Bruce Booth and Bijan Salehizadeh in an article for Life Sci VC. The life sciences and healthcare venture capital industry accounted for almost 30 percent of the $21 billion invested in venture-backed companies in 2010, according to PWCMoneyTree / NCVA.
But that doesn’t mean it’s easy for healthcare innovators to secure corporate venture capital. Funding for early and mid-stage life science development has dropped to 1994 levels, Dr. Frank Litvack, chairman & CEO of Conor Medsystems Inc., told conference attendees in Dallas in 2012. He added that a recent survey showed 39 percent of venture capital companies reducing their investment into life sciences.
We don’t see in life science venture capital investing the same kind of ‘halo deals’ secured by some media and tech companies, Booth wrote for Forbes. Though companies such as Amira and Enobia have seen successes in the five-to-fifteen-times range of returns, he said, life science firms can’t expect the 100-times and up returns of some tech companies. That’s because the life science venture model focuses more on higher consistency and lower rate of failures, Booth wrote.
Industry expertise and a deep understanding of the market is one benefit of choosing to accept money from a strategic, Paul Lee, senior vice president at GE/NBC Universal’s Peacock Equity Fund wrote for Fast Company. Another benefit, according to Lee, is that strategics are interested in taking more risk than traditional venture capitalists because these investments can reinvigorate – or replace – dying pipelines. Strategics can also offer the potential for an easy exit through licensing or acquisition.
Venture capitalists often invest in young companies expecting an initial public offering or sale within three to five years. The relatively short-term focus puts VC money out of reach for some companies and pushes others to make decisions that might not be in the company’s best long-term interests. A more patient alternative is the evergreen fund. Evergreen funds are funds that reinvest profits into new investments.
Tom Simpson, managing partner of Northwest Venture Associates, says evergreen funds offer some advantages compared to other funding sources. They’re often willing to invest for longer time frames, focused on longer-term, sustainable growth rather than quickly flipping companies. Evergreen fund managers are less distracted by fundraising, and that can lead to more attention paid to the companies the fund invests in, Simpson writes. The funds also have more flexibility because they can collect return from dividends as well as IPOs or sales. Evergreen funds don’t always come up in conversations about funding sources, but you’ve probably heard of at least one of them: Warren Buffett’s Berkshire Hathaway.
Other examples include the JumpStart Evergreen Fund, which invests seed capital in companies from a variety of industries that are located in northeastern Ohio. The fund seeks high-potential, innovation-oriented companies with unique, breakthrough and protectable ideas that have potential to serve at least a $1 billion market. Every company it invests in is paired with an expert advisor who helps set and achieve milestones, from gaining early customers and raising follow-on capital to appointing a board and hiring talent.
Rising in prominence with the 2012 passage of the federal JOBS Act, crowd funding lets entrepreneurs present their ideas to a large number of potential investors who can help startups reach their funding goals. The idea is for crowds to throw their support behind a particular project, driving consensus. Since a provision in the JOBS Act allows startups to raise up to $1 million through crowd funding, the technique is likely attractive to life science and medical tech companies.
Rather than using crowd funding to move from the idea phase to a market launch, medical tech startups would more likely be successful by seeking a small sum from crowd funding to help with technology validation and testing after developing a prototype, according to Brandon Glenn of MedCity News. Before considering crowd funding, entrepreneurs should invest in early development and seek grants, said Solomon Nabatiyan, founder of the crowd funding site TechMoola.
But for those startups creating expensive, complicated products, crowd funding might be best as a last resort. That’s because the $1 million crowd funding limit imposed by the JOBS Act won’t likely be enough to impact their development life cycles. And the number of investments it would take to garner $1 million – possibly hundreds or even thousands of small sums -- could prove more aggravating than worthwhile.
Startups interested in crowd funding should seek out “medical interest networks” dedicated to a particular disease or condition, such as patient advocacy groups, foundations, and clinical societies, said Baiju Shah, former president of Cleveland nonprofit business development group BioEnterprise.
Crowd Funding Platforms
Rock the Post
What Investors Want To Hear in a Presentation
From a short elevator pitch to a complete business proposal, there are a half-dozen ways for life sciences entrepreneurs to present their plans to potential investors, says John May, managing partner at New Vantage Group. Here are a few to have in your arsenal:
- The elevator pitch: Be able to articulate your business concept in 30 seconds or less. Let the potential investor know what you need from them and the next step for your relationship.
- The two-pager: This two-page document introduces your business to potential funders through categories such as management team, marketing plan, business model, and competition. Don’t forget to include your contact information.
- A PowerPoint presentation: This 10- to 15-slide presentation should contain no more than 10 slides of data, take no more than 20 minutes to present, and use a 30-point font, according to Guy Kawasaki, author and entrepreneur behind Garage Technology Ventures.
Once you’re in front of prospective investors, Bob Goff, founder of Sierra Angels, offers tips on making the first impression count:
- Within the presentation’s first two to three minutes, prospective investors should understand: what important need your company fulfills, why your solution is better than the competition, why the plan and management team are credible, and why the plan is a great opportunity for investors.
- Establish credibility by explaining your strategies for achieving competitive advantage, taking the time to drive home the credibility of your management team, and identifying key milestones.
- Demonstrate your “coachability” as a CEO by listening to prospective investors’ suggestions and showing you’re willing to explore these ideas as you refine your plan.
(More tips for making a good pitch to investors are available in the Kauffman Foundation’s Entrepreneurship Resource Center.)
Even with these suggestions in mind, there are several pitfalls to avoid when presenting your life sciences business plan to potential investors. Don’t focus on the science behind your medical technology, says Tarby Bryant, founder of Gathering of Angels. Instead, emphasize your product’s competitive advantage in the marketplace. Ignoring potential obstacles on the road to success means a missed opportunity to develop a robust startup that “likely will work in the real world,” says Russ Lebovitz, partner in Mercury Ventures. And don’t skimp on describing the exit strategy, says Steve Flaim of Tech Coast Angels. “Angel investors want to know how the startup will exit and when and why it will occur, and how much profit they’ll receive at exit,” he says.
An alternative to debt, equity or grants is revenue through licensing. Licensing allows a company to avoid dilution, but it requires a thorough valuation to determine whether shareholders are best served by licensing or by raising additional capital and becoming further diluted. Licensing proceeds can be subject to taxes. Hybrid agreements are possible in which the startup retains the rights to commercialization in its home market but licenses rights elsewhere, according to Avance, a company in Switzerland that specializes in valuation in life sciences.
Initial Public Offerings
Selling stock to the public not only offers liquidity to company founders, but it’s also “a signal to the world that the business has made it.” Going public can help a company attract talent, give it currency to grow and acquire other companies, and generally raise its profile. Getting there can be a long and challenging journey, especially for the CEO and CFO of an organization.
The conventional wisdom is that it takes life science companies longer to reach the IPO stage than it does tech startups. Bruce Booth, a partner with Atlas Venture, says that belief isn't backed up by the numbers, which show little difference among the various sectors. The median time it takes a medical device or healthcare services company to go from founding to an initial public offering is seven to 10 years.
In early 2012 there were 23 life sciences in the IPO queue, according to The Burrill Report. They included seven drug developer and 11 biorenewable companies. There were signs the IPO market was heating up, but two life science companies that recently went public, Cempra and Greenway Medical Technologies, both priced below their target range and raised less than they hoped, the Burrill Report said.
The downsides to going public include greater reporting and disclosure requirements, some of which can publicly reveal details of the company that it’s not used to sharing. For management, founders and investors, an IPO often means loss of control and a sudden, intense pressure to focus on quarterly earnings, which can detract from long-term plans. IPOs are also expensive. Fees and expenses can total as much as 25 percent of the deal.
NYSE and NASDAQ aren’t the only options. Some companies have recently looked to Europe, India and China as potential IPO locations. Tim Willis, CEO of North Carolina-based TearScience, which makes a dry eye treatment, said at a conference in early 2012 that the company was considering public markets outside the United States.