How to Invest in Healthcare Startups… from a Corporate Perspective

Written by Kunal Sharma

Venture capital is representative of the old developmental adage, “capitalism spurs innovation.” The majority of technical and scientific ideas that are widespread in society today were borne from a team of young, hopeful founders with promising technology. Start-ups can receive funding through many avenues: friends and family, grants and loans, angel investors, etc. At the top of that hierarchy, however, resides venture capital. Institutional investors that are willing to allocate large amounts of capital despite the risk are often the missing key to successful growth for small companies.

Recently, the industry has seen massive returns in the healthcare industry. This may be an intuitive conclusion, even from the perspective of someone who is fully uneducated on the topic of venture capital. Market fluctuations and capital influx to certain industries is heavily dependent on current international events. Between the recent pandemic and rising environmental concerns, numerous experts have stated that we’ll see large investments pour into those sectors, which coincides with rising investments in these sectors over the last few years.

Let’s backtrack and walk through the evaluation process of a venture capital firm in determining the strengths and weaknesses of prospective financial backings.

An initial screening of a company usually involves addressing the following: strength of technology or product, target addressable market, and intangible assets, an example of which is the management team. Only after this criteria has been cleared can venture capitalists delve into the financials of a company.

The strength of the technology or product is paramount to the success of a start-up. Specifically, in the healthcare sector, with an incredible technology, many shortcomings can be overlooked, as they’ll be corrected by more seasoned advisors. Consider a pharmaceutical company. The success of the founders and investors is fully dependent upon the functionality of the drug.

Target addressable market is a term used in the industry to measure the number of individuals to whom this product is relevant. How many people will it affect? The market for iPhones for example, extends to all individuals with the means of purchasing one, likely near 5 billion people. If the technology of the company only addresses a small portion of individuals, venture capital firms are less likely to flock to the company, as the return on investment is predicted to be relatively small.

The intangibles concerning the management team is a factor that is often overlooked. It is likely that the reader is familiar with the sentiment, “there is no such thing as an original idea,” coined by Mark Twain. Statistically speaking, if you’ve created a product, there is a significant chance someone else is pursuing one that is remarkably similar, if not the same. Why should a venture capital firm bet on you over them? In meetings between firms and founders, they often ask the question, “Why you?” (Sequoia).

Now, to reach deep into the financial health of the company. How do firms evaluate the financial standing of a company?

There are a few methods, one of which is relative valuation. For many early stage start-ups, proper financial analysis is difficult as cash is burnt quickly, so the best way to determine a potential return is through analysis of other, similar firms. Where did a competitor exit in the previous quarter? Comparing said company to others a little further along is called relative valuation.

Secondly, there is a term called the liquidity profile. There is a financial document called a balance sheet, in which a company compares its assets against liabilities. The formula, in theory, states that assets = liabilities + equity. In English, this is a balance of what is owed vs. what is held by the company. Liquidity can also mean liquid assets, or cash. The liquidity profile of a company, assets/liabilities, determines how much cash companies have.

Lastly, there is thorough financial analysis. Some of the terminology includes discounted cash flow, enterprise value, and multiples. These means are the most reliable in determining the health of the company, thereby signaling to venture capital firms whether or not they should invest. Truly defining these would require much more space than we have here, but feel free to look into them on your own time.

Let’s assume Company X passed all of these screens. How would they go about receiving funding from venture capital firms and other institutions?

The most common form of funding in finance is through rounds. These rounds are publicly announced by the company seeking investors, and they are labeled as Seed, Series A, Series B, and Series C, in order.  Whether it’s through angel investors or larger firms, the overarching goal is to extend the runway of the company. In the healthcare industry, cash is burned very quickly. Runway is the amount of time before a company runs out of cash; in the case of healthcare companies, the runway is pretty short, meaning they require a lot of funding. 

Each round signifies a match in progression of the company. If the funding comes in equity, a contractual distribution of company ownership to the individual or firm giving capital, then they have requests and deadlines to be met. Another form of funding during these rounds is through debt and lending. For this method, the only return necessary is a payment, with interest. To return to the point of the paragraph, the funding raised during rounds is used for expansion, new partnerships, product development, and to extend the life of the company. 

The average funding during seed rounds varies heavily, though there is more established data on Series A, B, & C. The Series A average valuation is $23 million, while the funding raised is $15 million. The Series B average valuation is $59 million, paired with funding of $33 million. Lastly, the Series C average valuation is $118 million, with an average of $59 million in funding (Reiff). These statistics were included to give the reader an idea of company size during these rounds, in addition to one more trend if you’re observant. The valuation increases exponentially compared to the funding raised. This is to show that somewhere between these rounds, the company is intended to become post-revenue, or profitable, using the capital from earlier rounds. Eventually, these companies are sold to another buyer or have an IPO, initial public offering. These means allow the company to seek guidance and funding from other firms, or become publicly traded and owned.

This paper would be most analogous to a 101 course on investing in healthcare startups, from a venture capital perspective. Though, if this topic is of interest to you, there is a voluminous amount of literature on the topic available online. Despite the negative connotation associated with financial pursuits in a corporate sense, I believe venture capital is the brightest pupil of the industry, supporting new innovation and development.

References:

Admin. “How Does Sequoia Invest?” GrowthList, 24 Feb. 2022, https://growthlist.co/sequoia/#:~:text=Sequoia%20may%20invest%20at%20the,of%20the%20most%20successful%20companies. 

“Philosophy.” SEQUOIA, https://www.sequoiafund.com/philosophy#:~:text=At%20the%20core%20of%20our,Index%20with%20less%20fundamental%20risk. 

Reiff, Nathan. “Series A, B, C Funding: How It Works.” Investopedia, Investopedia, 24 Feb. 2022, https://www.investopedia.com/articles/personal-finance/102015/series-b-c-funding-what-it-all-means-and-how-it-works.asp. 

Safavi, Kyan C, et al. “Health Systems as Venture Capital Investors in Digital Health: 2011-2019.” NPJ Digital Medicine, Nature Publishing Group UK, 4 Aug. 2020, https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7403411/. “What Does Series A, B, C Funding Mean: Investors, Valuations & More.” MacDonald Ventures, 16 Aug. 2021, https://macdonald.ventures/insights/what-is-series-a-series-b-series-c-funding/#:~:text=Below%20are%20the%202020%20averages,valuation%2C%20%2459%20million%20average%20funding.