We are fortunate to be in a period of unprecedented ophthalmic innovation. Across all dimensions of ophthalmology, from anterior segment to retina, from drugs to devices to digital ophthalmology, pioneering entrepreneurs are inventing, developing and commercializing new technologies.
But, most successful innovations need more than great technology; they require other key elements such as a strong management team and knowledgeable, deep-pocketed financial backers. After being convinced of the value of the new technology, financial partners generally decide on their involvement based on the size of the market opportunity and how much money is required to reach an optimal commercial and financial result.
The ophthalmology marketplace features a wide variation in these parameters. For example, at one end of the spectrum, innovations in small diagnostics or handheld surgical instruments may address small markets ($50 million annually or less) but have very short FDA approval timelines, allowing market access within months and requiring small amounts of capital (less than $10 million). At the other end of the spectrum, new drug development may be a multibillion dollar market opportunity but may cost $200 million or more and take 10 to 15 years to complete FDA approval and commercialization.
The capital requirements of a company dictate what financial partners are needed. If only a few million dollars are needed to get to commercialization or an exit (ie, a sale or IPO), “angel” investment or licensing/partnership deals can provide adequate funding. However, if the company needs more than $10 million to $20 million, venture capital investment will likely be required.
This article will focus on the financial aspects of successful innovation and the role of venture capital as a financial partner in these projects.
VENTURE CAPITAL: FRIEND OR FOE?
Venture capital is a $100 billion industry comprised of institutional investors focused on innovations with billion-dollar markets and capital needs of $20 million to $100+ million. Venture capitalists (VCs) are professional investors who are paid to generate high returns for their investors (generally pension funds, university endowments, family offices and other large pools of capital) through managing a portfolio of high-risk, high-return companies.
Venture capital for ophthalmology did not get its start until the late 1990s with early investments by Versant, InterWest Partners, Kleiner Perkins and others focusing on the field, creating many very successful large companies, several of them publicly traded.
What do VCs look for in ophthalmic innovation? Beyond the exciting technology:
- A huge market opportunity, $500 million potential or more.
- Good prospects for a high value exit in five to seven years.
- Most importantly, the project needs to be managed professionally by a strong executive team. This does not need to be in place on day one of investment but is a key element to be instituted after funding, to make the most prudent use of the capital provided with the goal of achieving high returns in a timely manner.
A common misconception is that VCs want control over the company or want to run it. This is generally untrue. VCs want to delegate control of the company to a competent management team and almost never take an operating role. Generally, VCs own a minority of the company (10% to 30%) and sit on the board of directors but do not have a majority control position.
Most VCs want to retain the founding entrepreneurs in the company, provided they can work as part of the team. The best companies can keep the founders through the whole evolution of the company, much like Google and Facebook are still run by their founders. However, not all founders can work well with a diverse business team. Some evolve to become consultants to the company rather than having operating roles, while others move on to start a new venture, often with the same VC backers as the prior company.
WHEN SHOULD YOU SEEK A VC?
There is no firm rule, but if the project is capital intensive (>$20 million required), it is difficult to fund without institutional capital. However, VCs are often risk averse and do not want to fund raw startups, so it is usually best to raise some angel money to achieve a proof of principle or initial data to prove some value of the innovation. Almost all VC-funded companies have previously raised angel funding, so this is a key first step in being ready for venture capital. There is no firm recipe for the threshold entry point for VC, but key elements include:
- A strong business plan communicating the potential of the innovation
- Assessment of market size
- Indications that the innovation serves an important unmet need
- Evidence the innovation can be patent protected
- A likely FDA pathway
- Working prototypes
- Early animal or human data
- A commercialization plan
- Plans for formation of an impressive management team if one is not in place
Getting the attention of VCs is difficult. They are busy multitaskers and most already manage a portfolio of companies, so introductions are critical to get them to review a business plan or take a call or meeting.
VC introductions commonly occur through e-mail or through a person known and trusted by the VC. A one-page executive summary is often enough to give an idea of the innovation, as most VCs do not read a detailed e-mail or long PowerPoint presentation. Presenting at conferences is another way to get exposure to VCs, but only a few conferences have a high number of VCs in the audience.
The Ophthalmology Innovation Summit is one excellent forum to get exposure and possibly network with VCs, but there are other investor conferences such as the JP Morgan Healthcare Conference that are also excellent platforms.
WHAT DO VCS WANT?
VCs are seeking very high returns for their investors. Winning investments need to be true home runs to compensate for the reality that many of the companies in their portfolio will fail. In ophthalmology, a target outcome is often a five-fold return in five years. Internal rates of return are also important, and rates of greater than 20% are expected. Most returns are driven by a high value acquisition by a large multi-national company such as Johnson & Johnson or Alcon or, more often now with a strong public market, through an IPO and subsequent sale of publicly traded shares.
As part of a risk mitigation strategy, almost all VCs invest only in preferred stock so that they get paid first in a sale of the company. Most also require a seat on the board of directors along with quarterly board meetings and frequent financial reporting, sometimes monthly.
As mentioned earlier, they are not generally focused on control but rather prefer to be significant minority partners with a voice in the direction of the company.
A frequent topic of discussion and often tension is the valuation of the company by VCs. VCs generally apply an analytic approach to valuation that is often in contrast to the entrepreneur’s more intuitive sense of valuation. There is no right answer to what a “fair” valuation is, although sometimes outside valuation consultants can be helpful. The methodology that often allows both parties to agree considers comparable companies with recent financings, or discounts back a present value from more mature public companies with similar products.
Dilution (ie, a decrease in the ownership percent of prior shareholders) will always exist with any new capital infusion. However, if ultimately the new capital greatly increases the value of the company, this dilution is a very positive tradeoff to make. In venture-backed companies, most management teams hold 20% to 25% ownership at the time of exit, even after raising hundreds of millions of dollars. The most common reason for failure of early-stage companies is running out of money during product development. Stated another way, regarding dilution from outside financing, “Better to get a small piece of a giant pie then 100% of nothing.”
WHAT IS “A FAIR DEAL”?
It is often hard for entrepreneurs to assess complex VC offers and term sheets. A key resource for any entrepreneur is retaining legal counsel experienced in startups. Their expertise is invaluable in judging any potential deal and analyzing the various aspects beyond valuation, such as preferred stock terms, voting rights and anti-dilution provisions.
In general, most experienced VCs will offer standard terms that are familiar to start up attorneys, and most can be negotiated from the initial offer. Some red flags for “bad deals” are draconian valuation compared to similar companies, unusual control provisions or “blocking rights” for the VC or conditional funding based on yet-to-be-named co-investors.
Ophthalmic innovation is at an all-time high, providing a rewarding but often challenging business proposition that usually requires multiple constituents and robust funding. Venture capital is the most common source of funding for high-risk, high-return ventures that have billion-dollar potential, but entrepreneurs need to be strategic in how and when they engage with VCs. As proof positive of the model, there are now a long string of VC-backed ophthalmology companies, such as IntraLase, LenSx, Glaukos, Eyetech, Aerie, Spark and others that have produced successful FDA approved products and $500 million to $1 billion exits for their constituents.
Through raising large amounts of venture capital in multiple rounds, entrepreneurs and shareholders have benefited greatly from the partnership and the billion-dollar sized valuations created. This bodes well for the next generation of companies currently being developed by ophthalmic entrepreneurs. With a large amount of venture capital still waiting on the sidelines, potential investors are standing by for the right ophthalmic opportunities. OM