Diligencing Healthcare Companies, Part IV: Team, Exit, and Risk.

Introduction

In Part III of our series on diligencing healthcare companies, we continued our deal memo work by examining how companies turn untapped market opportunity into financial value. Among other factors, we examined which specific healthcare stakeholder the company will initially target, the unit economics used to estimate the revenue opportunity, and why they will stand out among the competition.

Ultimately, as investors we invest in the company for financial return. Now that we understand what the startup is working on, and how startups will make money, it’s time to understand how likely we are to generate an invest return by analyzing who the team is and why they are the best fit for this venture, the likely outcomes for the company, and the potential risks along this journey to achieve venture outcomes.

Team: Finding Founder-Venture Fit

Key Takeaway

Perhaps one day, we will see companies created completely from scratch by AI, but at this time, we’re still dealing with fleshy human beings driven by their ambition and emotion. Understanding the makeup of the founding team and key early hires is important in understanding how likely we can achieve a positive exit for our investment.

Many investors talk about pedigree (successful exit, FAANG, Ivy league education), but we tend to view that as a nice to have and not a must have. Sure, not everyone went to an Ivy league institution or worked at FAANG, but Ivy League schools create ~45,000 graduates a year, and 5~10% yearly employee turnover rates at FAANG (collectively with ~1.5M employees) for a total of 75K-150K people per year, “pedigreed” founders are not as rare as we think.

Instead, we would rather explore why they are the best fit for the venture at hand, and what makes their journey prior to starting this venture unique. As we mentioned in the last article, healthcare companies tend to be solving known problems to achieve known outcomes, and the more unique their path to understanding the problem is, the better we’re positioned to have a unique (and likely positive) outcome.

Specific Healthcare-Oriented Questions:

What unique experience led them to this venture?

Many of the problems in healthcare are not purely technical in nature. As such, we favor founding teams who have personally experienced the problem first hand, or have ground level observation of the problem. Zocdoc, one of the first online doctor booking portals, was started because the founder couldn’t find a doctor for his ruptured eardrum; Flatiron Health (acquired by Roche in 2018) was started because the founders found it difficult to research cancer treatments for their loved ones.

Who are the key hires outside of the founding team?

While some expect to see one person billion dollar companies appear with the help of AI, that future isn’t here yet. It’s unlikely the founding team will be able to cover all the components (product development, regulatory, commercial, etc) necessary to build a successful healthcare company.

Most healthcare companies we see are led by technical founders who have spent years honing the technology, and they will need most help with a commercial hire. While we strongly believe in founder-led sales, having a strong commercial hire or advisor who is familiar with the lay of the healthcare land, and can point the founder in the right direction is critical.

Fundraising milestone: How will the company use money?

Key Takeaway

While syndicates like ours can invest at any stage of the fundraise, you’ll typically find us operating at the preseed - series A, where companies are raising <10M USD.

Considering most healthcare unicorns raise at least $100M to get to billion dollar valuations, companies at this stage are unlikely to solve all their issues with this early raise, and will have to be laser focused on the most important and urgent problem to spend their limited resources on.

Specific Healthcare-Oriented Questions:

What are the key milestones needed to achieve prior to commercialization?

Part of the challenge of building healthcare companies is that they are much more stage gated than other industries. Unlike SaaS companies that could get started with a founder with a laptop and a good internet connection, healthcare companies need to go through more go/no-go checkpoints before officially selling their product. Some examples are:

1. Clinical Trials: Does this product work or not in a clinical setting? Key questions include:

   • How many trials does this product require?

   • Has the FDA reviewed the trial design and provided no negative feedback? (note that FDA does not give any definitive YES/NOs prior to an official submission)

2. Regulatory Approval: Does the government need to approve this product? See our previous article on the various FDA product classifications.

Ultimately, our goal is to invest at a stage where there would be a significant inflection point in the company’s valuation at the next fundraise.

Exit Opportunities: How will investors make money?

Key Takeaway:

Assuming that the founders are aligned with investors on driving an exit for the company, M&A and IPO are the primary ways we generate returns in venture investing. While we are willing to invest in category defining companies that will be the first to show the market what a positive financial outcome looks like, understanding market comps and past exits is still a useful reference to understand what market activity has been in the space to anchor the exit story.

A note on chasing unicorns: Multi-billion dollar exits are never guaranteed, no matter the pedigree of investors, and be aware that they might even be playing stupider games. 

Specific Healthcare-Oriented Questions:

While IPOs exits are always the dream for any early stage investors, most healthcare exits occur via M&A, and typically at $100M-500M valuation. Understanding that reality will help set the right expectation for investors for the type of entrance valuations fora given desired exit. If we are targeting typical venture returns (10X return in 10 years for a ~25% IRR), then we need to invest in companies below $10M valuation.

Risk: Where are the pitfalls?

While the number of risks are many in early stage venture, we try to quantify at least one risk at two different time horizon:

1. Short term risk: Typically associated with events that could influence the likelihood of the company executing on their key milestones. Here we try to focus on risks that alter the trajectory of the company (ex: speed of market adoption, technology development challenges), as opposed to binary risks associated with key milestones (failed clinical trials, regulatory rejection), since the latter tends to be related to inherent risks of building a healthcare company, and/or can be mitigated by professionals well before they execute on said milestones.

   For example, a key clinical procedure associated with the company’s product may not be well accepted by clinicians, and may require the company undergo additional real world studies to prove their safety and efficacy before seeing significant adoption.

2. Long term risk: Typically associated with events that could render what the company (and any other competitors utilizing a similar approach) is doing irrelevant. These tend to be risk associated with change (or lack thereof) in customer behavior, regulatory changes that invalidate a certain approach, etc.

   For example, the end of Public Health Emergencies enacted during COVID has thrown digital health companies’ businesses dependent on expanded telehealth usage and relaxed reimbursement criteria into doubt.

At the end of the day, there is always some level of risk in early stage companies, and the key is to understand if company leadership has thought about this risk, and whether they have thought of some potential mitigation strategies.

Using the example in the short term risk section, a company may have key KOLs that are influential in their specialty as advisors, or secure early partnerships with leading medical centers in their field that see a large portion of patients in order to convince other clinicians to adopt their product.

Conclusion: Revisiting the “Who” and predicting an exit.

Building a startup is often described as “building a racecar while the car is moving”. No matter what the racecar (problem, solution, business model, etc) ultimately looks like, understanding who the driver/assembly person is (team), and where they’ll drive the company towards (exit opportunity), is how we tie all the previous diligence work together back into a cohesive story that directs our final investment decision.

And that’s a wrap! Thanks for following us over the last few weeks as we delved into how we diligence healthcare companies at The Healthcare Syndicate. From here on out, we’ll continue to share our thoughts on early stage healthcare investing, so stay tuned!

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