An emerging med tech company is like a family. There can be lots of drama. With the inevitable cycle of successes and setbacks in our highly regulated, unpredictable industry, the little corporate family can rally together or come apart at the seams. And if you are a leader of a development stage med tech company (see this S2N Blog post to know if you are a good one), you may see your coworkers more than your own real wives, husbands, and children. Your colleagues are your peeps, like it or not.
When an investor puts money into your company, their role in the cozy corporate family is not that of distant relative coming to visit, kitschy gifts for the kids in hand. The more appropriate mental image is the mother-in-law moving permanently into your converted garage, especially if the investor takes a board seat. For better or worse, this investor is now part of your intimate little family, along with management and fellow investors (it’s a big converted garage).
In a functioning emerging med tech family, there is a healthy level of tension among the various stakeholders, each with a unique perspective on how best to grow the value of the company (and thus their stake in it). Sometimes, though, the incentives and motivations are in such opposition that value or even whole companies can be destroyed, or worse just limp along zombie-like in defiance of all logic.
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So where do the wheels come off the bus? To answer this question, we sought the wisdom of John McDonough, CEO of T2 Biosystems and deep thinker on the topic of leadership alignment in VC-backed companies (John will show you his battle scars if you ask nicely). John has observed two basic varieties of misalignment in these companies.
Big VC vs. Small VC
Many emerging med tech companies raise funds from angels and small investors in the early rounds when capital requirements are relatively small. As the infant technology matures into the hungry adolescent, larger venture capital companies often enter the mix.
A big VC typically wants to put lots of money to work for a handsome return (though 10X doesn’t really happen anymore). In contrast, small investors by definition don’t have as much capital to put in, so they are generally fond of lean operations and a quicker exit for a smaller return.
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While this motivational divide among investors is combustible enough, it is usually accompanied by an imbalance in financial terms terms that throws gas on the fire. “When the big VCs enter in the later rounds, they may demand all sorts of preferences that leave earlier investors with all the risk and big caveats to their upside potential,” says John.
An example of intra-investor incentive misalignment and the unfortunate sequelae can be drawn from John’s deal-making days at Cytyc Development Corporation (now part of Hologic). “When I was at Cytyc, we tried to acquire a pre-IPO company. Our valuation was on the high end of traditional revenue multiples, but the late stage investors would have had to accept roughly a 3x return on their investment. The early investors were excited because they were looking at a 5x plus return on their investment. Because of the capital structure of the company, which included different terms for each class of securities, the late stage investors were able to block the transaction. It never happened and we walked. To this day, now over 5 years later, that company is still private and has not done well. In this case, there was misalignment on exit multiples and returns within the fund.”
Investor vs. Management
Just like the early investors, the founders and management team can also get left in the cold as new, larger investors enter the scene. The later investors may think they got a sweet deal, but a demotivated team generally is not a ticket to success. “Investors sometimes outsmart themselves, not recognizing that management will control what actually happens in the end,” says John. Harking back to his Cytyc-era example, John adds, “Now all the players involved wish we could have driven the deal home. Management of course lost big time. They wanted to do the deal but had no voice in the ultimate decision.”
So how can this misalignment be avoided? The right investment structure is critical. “Sometimes it is better for early investors and management to accept a lower valuation when new investors come in, take the dilution, but keep all the investors on the same terms,” advises John.
It is also important to pick investors wisely, when one has the luxury. Here are a few things to consider before bringing a VC into the fold (due diligence is a two-way street, you know):
Time pressure: “Where is the VC in their fund? How hungry they are for exits? Does their timeframe fit the company’s likely path?
Experience: Has the VC done similar deals before? Where have they been burnt? Will their expectations of the company be grounded in something akin to reality?
People: Who is going to serve on your BOD? Will they contribute productively? What do they bring to the table? Have they worked successfully with other members of the BOD before?
With the right mix of investors joining the family dinner table, and no one feeling relegated to leftovers vs. the chateau briand, serious indigestion can be avoided. It could even be a pleasant meal.
