Digital health investment topped $6.8 billion in the first three quarters of 2018, by Rock Health’s reckoning, marking a new milestone and underscoring the point that there is a lot of funding available to digital health startups. But despite this, it is critical for startups to consider several questions about their company’s strategy before they take outside funding, each with their own set of advantages and disadvantages.
What’s the end game?
After relying on their own pockets and then friends and family, entrepreneurs may be keen to take outside funding, but their first consideration should be, “How much do I really need for the next 12-to-18 months? Which, of course, depends on the lifecycle of their product,” said Rachel Polson, a partner with accounting and advisory firm Baker Tilly. Startups need to consider how much ownership they’re willing to give up in exchange for this funding. Because most of the time when people are doing investments, it is an equity investment. It’s one thing if there’s one founder, but what if there are three or four? If they give up 20 percent will they be able to retain control of the business for long?
Rachel Polson, Baker Tilly partner
“Consider the life cycle of the company,” Polson advised. “When will you be cash flow positive? Is this funding for the next 12 to 18 months really a band-aid to get you to this stage?” Polson noted that companies should evaluate the funds necessary for true revenue generation and cash flow at that break-even point and consider if another funding may be needed 18 months down the road.
“How much ownership will you be willing to give up when that happens?”
A Deep-dive Into Specialty Pharma
A specialty drug is a class of prescription medications used to treat complex, chronic or rare medical conditions. Although this classification was originally intended to define the treatment of rare, also termed “orphan” diseases, affecting fewer than 200,000 people in the US, more recently, specialty drugs have emerged as the cornerstone of treatment for chronic and complex diseases such as cancer, autoimmune conditions, diabetes, hepatitis C, and HIV/AIDS.
Polson noted that there is something to be said for companies that hire more staff to get to market faster, but that can be more expensive. If you have to do a large Series A round that has terms that are more expensive than what you would normally want and you’re having to give up warrants or the conversion feature, those options may not be best for retaining ownership but they do get their product to market faster.
How much do you need to raise?
The quandary startups face is they need to get to a minimum critical mass of revenue in order to survive. Raising too little of funds comes with its own set of risks as raising too much, according to Mike McKee, a partner with Baker Tilly.
“You have to raise enough money to get up to at least $10 million to $15 million in revenue to get to a Series B. The risk is if you raise too much at too high a valuation early on, you are forced to do a down round later on. And that has all kinds of negative implications. You may have to reprice the initial equity round, resulting in further ownership dilution.
Mike McKee, Baker Tilly partner
Funding velocity
McKee observed that one trend that the firm is seeing is the shrinking of funding velocity –the timing between the Seed Round and the Series A — is shrinking.
“You have more investors willing to invest at that Series A level. You are seeing all this interest in digital health from non-healthcare companies such as Best Buy’s acquisition of Great Call for $800 million. You have Amazon and all of these traditionally non-healthcare companies taking an interest. So that is probably how they justify making earlier investments.”
Polson noted that if venture investors think strategic players are going to snap up a tech company, that’s a home run and plenty of motivation for venture capitalists to invest more money at earlier, riskier stages of digital health startups than they did 10 years ago.
Too much of a good thing?
One risk of raising too much funding is that companies make what seem like poor decisions, such as a pricey marketing campaign or moving into plush new offices.
“A lot of the startups we have seen have had to weigh that extra spending on things that weren’t essential,” McKee said.
Polson acknowledged that some of it is about perception. Some people think because of the Minneapolis market, where companies might find it tougher to attract qualified candidates than in the Silicon Valley or Boston, for example, that a plush office could help attract engineers, developers, and other technology talent.
Tax reform benefits
McKee noted that the Congress passing tax reform has led to benefits for many of his firm’s clients. While some are using it to buy back stock, for others it is fueling increased spending for M&A.
For Polson, it means that more companies are open to being a C-Corporation, because the tax rate has fallen from 35 percent to 20 percent, making it more attractive to companies. Before, companies preferred to be LLCs because of the lower tax rate.
“Companies are talking upfront about how this fits into their strategy compared with before when it used to be an automatic decision for a startup to be an LLC. Now they need to have more of a dialogue with a CPA firm that understands the whole tax reform landscape. When you think about how you want to set up your company, tax reform has made it more complicated.”
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