NOMOS was funded almost entirely by a single wealthy businessman, an “angel” investor who was a friend of the Founder’s family. At the time of his initial investment, he knew nothing about the medical device business but over the course of a decade, he learned enough to become the CEO of the company. While there were other investors, the amounts were never significant.
Having such a wealthy individual supporting the company was a blessing and a curse. It was comforting to know that there was money to fund the Founder’s ideas for new directions, and employees knew their paycheck was never at risk. The Chief Financial Officer knew that the books would always be balanced at the end of the year, and the sales team knew that while revenue was important, the company was not going to fail if they did not meet their yearly quotas.
However, the curse was a lack of governances that normally would ensure that money was spent wisely, resulting in a less than optimal way of deciding which paths to take when it came to allocation of investment dollars. Perhaps more importantly, NOMOS failed to secure any institutional or formal investment. While the Founder held multiple funding rounds, at the end of each meeting with investment banks and venture capital (VC) firms, the angel reminded him that he could always fund the round himself. That is, in fact, what invariably happened.
At the time the company was founded, the angel and the Founder agreed to split ownership 50/50; the Founder would contribute ideas and execute, the angel would contribute business acumen and funds. This sounded great to the Founder at the start, especially to a student fresh out of college with great ideas but no way to fund them and no experience in securing funding from others. However, over time, the arrangement led to a complete rebalancing of ownership. Each project required more funding, and a growing percentage of the company came under the control of the angel. The argument was logical – if the Founder had to go elsewhere for funding, ownership would transfer hands to the investor, so the same situation should apply to the angel. The Founder assumed – and everything in the literature supported the idea that – money translated into ownership while inventions translated into opportunity. Although the Founder’s ownership position would grow progressively smaller over time, the market opportunity would increase progressively, meaning the Founder’s position was improving. The Founder, however, failed to secure a guaranteed minimum ownership position that would protect him from total dilution, nor was an option plan put in place that would translate into value should the company go public or get bought. By the time the Founder left the company and it was sold, the original Founder, the source of most of the intellectual property, owned less than 0.1% of the company.
In 2001, while the market for its products was at its strongest, NOMOS embarked on the public market path, with an initial public offering (IPO) set for July 24, 2002. The IPO was expected to generate proceeds in excess of $50 million. However, two days before the IPO, WorldCom filed the world’s largest bankruptcy filing to date, resulting in what was at the time the seventh worst single day point-loss in Dow history. The NOMOS IPO was canceled. NOMOS ceased to exist as a standalone company in October of 2004 when it was acquired by North American Scientific (NASI) for $12 million plus $40 million in stock (at about $7 per share) in a deal valued at a total of $60 million. At the time NOMOS was generating around $30 million in gross sales from all its business combined. In 2007, NASI sold the NOMOS business line for $500,000 in cash plus assumption of $3.1 million in certain obligations and liabilities for warranty and maintenance agreements. At the time, NASI stock was valued at around $0.30 per share.
Healthcare innovation presents many financial challenges:
- Funding the innovation’s development
- Determining the price point for the product or service it offers, including an optimal price structure for capital and single use components of the technology
- Estimating the time and money it will take to reach cash flow positive once the technology is in the market
- Timing fundraising so as to provide the required amount of capital without diluting the ownership position of existing shareholders more than necessary
- Optimally timing the manufacturing and marketing ramp ups, knowing that ramping too early will deplete cash reserves while ramping too late will risk incurring lost opportunity
One of the first hurdles facing a new technology is funding its development. At the earliest stage, a company’s worth is low, and the cost of raising money is high for the entrepreneur because there is a high level of risk involved. As the company realizes major milestones, thereby reducing risk to the investors, it can raise progressively larger amounts of money at lower and lower costs to support hiring, production, clinical trials, regulatory and reimbursement activities, marketing, and other value-building activities. Regardless, for healthcare startups that are early in the growth process, securing funding can be a difficult and time-consuming process.
The challenge of identifying an investor pool is complicated by the long investment time needed for new devices that require US Food and Drug Administration (FDA) approval and insurance payor coverage. Targeting the wrong pool may prolong the entire development process. While VCs backing an information technology start-up may be able to get their investment out in two- to three years, investors in a biotech firm may have to wait ten years just to find out whether a product or drug will be authorized for use. Many traditional sources of capital, including private investors and family funds, are not familiar with the healthcare industry, so while they might be attracted to a concept or a market, their lack of knowledge about that market may make it difficult for them to invest.
There are a range of funding vehicles that can be used, often in combination, to fund a company during its various stages of growth:
Non-dilutive funding means that investors do not own a piece of the company. Some examples of this type of funding are below.
- Incubators – Public, private, or academic incubators offer subsidized business accommodations, academic support and business mentoring, and connections with resources for prototyping, testing, and clinical trials.
- Entrepreneurial competitions – Universities or large companies hoping to attract technology partners often offer technology contests with sometimes significant payouts in cash and in-kind services.
- Technology development grants – The Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) are federal programs that provide more than $2.5 billion in federal grants to domestic small businesses to stimulate technological innovation. To be eligible, companies must be for-profit, more than 50% owned and controlled in the US, and have no more than 500 employees. These programs are structured in three phases.
- Phase 1: Awards between $50,000 to $250,000 for six months in SBIR or one year in STTR. The objective is to determine technological merit to the research and development and the commercial potential of the product.
- Phase 2: Awards are generally $750,000 for two years. Funding is based on the results from Phase 1 study, and typically a Phase 2 award is only granted for those who received a Phase 1 award.
- Phase 3: There is no SBIR/STTR funding for Phase 3. However, there may be follow-on non-SBIR/STTR government funding for products or services intended for use by the government.
- National Institutes of Health (NIH) – NIH is made up of 27 institutes and centers (ICs), each of which has a distinct mission that focuses on a disease area, organ system, or stage of life. ICs award more than 80% of NIH’s annual budget to support investigators in these areas while only about 10% of the NIH budget supports NIH laboratories.
- Crowdfunding – Crowdfunding is most effective after the early development phase, when the funds are needed for validation or prototyping. The same high-risk and high capital needs medical technology that made VCs chary of medical technology make the crowd a less optimal source of cash.
- City, state, and county resources – Local governments often use tax breaks and other incentives to draw entrepreneurs to development zones. Technical associations have been formed in most areas to boost industry, some with their own tech incubators. Trade associations offer access to universities or hospitals for clinical testing and connections to local angel investors and competitions. They can also provide opportunities for networking and mentorship.
With dilutive funding, investors own a piece of the company in exchange for their support. Some examples of this type of funding are below.
- Angel investors – Individuals with deep pockets and an interest in a specific disease or condition will invest money to help get a nascent idea off the ground. These individuals can be firms, friends, patients who have suffered from or been treated for the clinical condition the technology will address, or individuals knowledgeable in the field who want to see an idea succeed.
- Private placement – Private placements – the sale of securities to a relatively small number of select investors – can be used to fund a vision by raising money from individual donors.
- Traditional VC firms – VC funding is typically available for companies in a later phase of growth when they are two- to three years away from an IPO or sale. Typical VCs invest larger amounts of dilutive money, ranging from several million to $100 million or more. Today, most VC funding in early rounds is going to telemedicine, mobile health apps, data analytics, and clinical decision support companies.
Stages of Fundraising
Fundraising can be divided into stages, with each successive stage requiring more money than the prior stage but at a lower cost of money. In general, these stages are pre-seed, seed, early, growth, and exit. It is common for different types of investors to specialize in different stages; each has its own set of needs and goals.
A pre-seed funding round takes place early in the product development stage. Startups raise pre-seed funding to flesh out the idea and create a proof of concept, thereby bringing them to a level where seed money can be raised. Historically, pre-seed funding has been referred to as the “family and friends” stage, with this money being added on top of personal investments, credit card debt, refinancing of a home, grants, and more. Typically, the sums required are in the $10,000 to $50,000 range, which is manageable without going to professional investors.
Usually lasting three to nine months in duration, the seed stage is when the concept is turned into a true working prototype, some traction is gained amongst the targeted demographic, and the company is given a name, a brand, and the start of a personality. Funding comes usually from the same sources as the pre-seed round or from an “outside the family” angel investor, with the growing need for capital reaching $250,000 or more. As investors face the reality of a business that will require significant investments to reach success, and as the field of investors begins to fall outside the personal, an investment will demand a greater ownership position on the part of the investor who will require greater growth potential than might be expected at a later stage of investment. This is the most expensive money a successful startup will raise, because the risk is the greatest. For companies that fall on hard times over the course of the commercialization process, more expensive money may be required later to keep the company alive.
Early-stage funding usually comes from sources other than family and friends and angels, because the amounts are greater, typically in the range of $500,000 to $2 million spent over 12 to 18 months. These funds are used to build a management team, create a clinical device, conduct preclinical trials, build a quality management system and production capability, and prepare for regulatory and reimbursement activities. The cost of money is less, because there is now some sense of a working technology and real market opportunity. Investors at this stage need to be prepared to invest more money over time to preserve their ownership position. This requires investors with greater cash reserves, leading to a role for one or more VC firms or high net-worth private investors.
Growth capital, required once a company has regulatory authorization to sell, is used to turn the burgeoning business into a real business complete with sales and marketing and service organizations, a full management team, and a growing manufacturing capacity. There may also be the need for additional clinical trials to meet regulatory or reimbursement requirements or to investigate additional applications of the technology. Growth capital comes from VC firms that are already investors in the company and new VC firms. Industry partners often participate at this stage of the fund raise, and they may also strike licensing or other deals that provide non-dilutive investments.
Debt financing is an option at any point in the timeline. Debt financing is the process of borrowing money from a source outside the firm to continue operating the business. The business is responsible for paying back the principal amount according to the terms of the loan, plus some percentage rate of interest. A repayment schedule for the principal and interest is established at the time of the financings. Debt financing may be short-term, with a maturity of less than one year, or long-term, with a maturity of more than one year. Debt may be “secured debt,” backed by some form of collateral, or “unsecured debt.” Debt financing does not require that the owner or manager of the business give up any of their control or ownership stakes and is considered non-dilutive. This non-dilutive nature makes debt financing attractive to many early ventures.
Debt financing may be difficult to obtain in the early stages of a business because the company does not yet have a proven or reliable track record. It must be kept in mind, however, that a business must repay the borrowed money. Too much reliance on debt financing will cause a business to have a lower cash flow since principal and interest payments must be made on the debt. The company also must repay principal and interest regardless of its cash flow situation. If the business shutters, the debt still must be paid. Debt lenders will have a claim for repayment before any equity investors if the company is forced into bankruptcy.
After a company is successful, or at a point when it is clear it is going to be successful, existing investors may decide it is time to cash out. Different types of investors have different end goals, ranging from growing an operational business to continuing to increase shareholder value to providing a vehicle whereby a profit can be earned. There are multiple ways to achieve each of these – management buyback, employee stock ownership plan, IPO, acquisition – but it must be recognized that not all end games will be aligned among all investors, and that conflict resolution may be required.
These are very loosely defined stages in the fundraising process and can vary based on the specific needs of the company and its internal financial resources. It is important to target the correct investor pool at each stage; doing otherwise may prolong the entire development process. For instance, looking for an industry partner during the seed stage is liable to be futile, because industry is usually risk-adverse and willing to pay more to acquire or invest at a higher valuation once it is clear the technology has a future. Conversely, looking for angel investors at the growth stage is unlikely to bear fruit, because the investment and reserves required are too great while the return is too low for their portfolio.
Timing of Investment
Every development and commercialization process incurs setbacks and delays, yet corporate development plans rarely factor sufficient delays into their timelines or funding requirements. For instance:
- A component or sub-assembly may not perform according to specifications and must be reconfigured.
- The results of a preclinical trial may necessitate a product redesign.
- The FDA may require additional information or even a resubmission incorporating new data.
- The issuance of a reimbursement code may be delayed due to a lack of clinical publications.
It is common for a company, once it enters the early development stage, to complete large financing rounds broken down into milestone-based tranches. This financing structure provides a start-up with the security of knowing it is sufficiently funded for the near future, freeing management to focus its attention on developing the product and building the company. It is much less risky and time consuming than having to go back into fundraising mode after each milestone is achieved.
For this approach to succeed, however, the company must achieve its milestones within the timelines and budgets to which it has committed. A three-month delay in realizing a milestone represents three months of funding need for which there is no money. The company may have too little cash to reach the milestone that triggers the next cash infusion. Whether that milestone was part of a tranche financing round or whether it was supposed to trigger a new external financing round, there is now a funding gap that needs to be filled. This gap takes time out of other work and can be quite expensive in terms of valuation. Medical device start-ups literally cannot afford to assume (and create expectations for) a ‘hiccup-free’ development process. Setbacks and delays in sub-processes along the development and commercialization timelines must be included up front to ensure adequate funding resources and aligned expectations on the part of those providing the funds. The temptation to present a rosy picture, with the idea that this will lead to a greater number of willing investors and a higher valuation, must be avoided, since the cost of doing so in terms of time and money, should all not go according to plan, will be much greater.
Creating a technology price structure that allows the company, investors, and hospitals to realize a profit requires thoughtful strategizing from day one. It is highly likely that an effective strategy may depend on the target market and how the company is funded. Identifying the best strategy for a given venture requires an understanding of corporate and investor goals, the target market, the reimbursement process, and the technology’s clinical value.
Academic institutions help provide the positive press a company may need to gain widespread adoption of a technology and generate investor interest, but there are many more non-academic selling opportunities. Academic institutions, flush with grants and benefactors supportive of the purchase of capital equipment but with the need to finance daily operations from services provided, may prefer a model featuring a high cost ‘razor’ – in this instance, the equipment – with a low-cost ‘blade’ – or the ongoing procedural and disposable costs. This approach will maximize positive operating cash flow from each case.
Smaller institutions and physician-based operations with limited access to capital may prefer a “free” razor with a pricey ‘blade’ covered by procedure fees. For the manufacturer, gaining a large corporate revenue stream from capital sales is great, but without a high-priced disposable, it may be difficult to get a payment rate from the Centers for Medicare and Medicaid Services (CMS) that will encourage cases to be performed. The disposable can be a large charge added into the cost of the procedure thereby increasing the payment CMS sets for the procedure. However, if the technology will be paid using existing codes, then a high disposable price may not be tenable if that price pushes the cost of the procedure higher than the payment level already in place.
On top of this, investor needs vary, with some preferring a recurring revenue stream while others tend toward a capital sales model. Since each of these approaches to the market carries with it a different valuation model if it comes time to go public or be acquired, some idea about exit strategy may be required when contemplating a pricing strategy.
There is no right answer when it comes to pricing a product. What is necessary is an active discussion including all stakeholders so a path forward can be identified early on that aligns a pricing structure with expectations on the part of the company, its board and investors, and its sales targets with a reimbursement format that will ultimately determine the success of the technology.
Pivoting on a pricing model down the road is certainly possible, especially if market dynamics change due to competition or changes in payment policies (for instance, if the US were to move more aggressively from the current fee-for-service model to a capitated disease management payment environment). Keep in mind that it may be difficult to convince payors that a single-use item that previously cost $1,000 is now going to cost $5,000, or that a capital purchase that a hospital projected was going to cost $50,000 is now going to cost $500,000. Since major changes in pricing structure may produce uncertainty in the market, buyer’s remorse on the part of investors, and most likely lengthen the time to cash flow positive, these changes should be avoided as much as possible.
Each of these areas is important to consider when addressing the financial challenges presented by companies engaged in healthcare innovation.
Mark Carol, MD, is a senior consultant at the Focused Ultrasound Foundation.
Read the Series
- Part 1: The Complex Ecosystem of a Medical Device Startup
- Part 2: Novel Technology Development
- Part 3: Regulatory Authorization
- Part 4: Reimbursement
- Part 5: Physicians
- Part 6: Patients
- Part 7: Facilities
- Part 8: Societies and Guidelines
- Part 9: Commercialization
- Part 10: Technology Advancement
- Part 11: Publication Strategy
- Part 12: Cybersecurity
- Part 13: Financial Challenges