Chapter III.2.10
Entrepreneurship in Biomaterials
Introduction
Start-up companies are an integral part of the biomedical product development landscape. Although most medical devices are manufactured, marketed, and sold by large companies, their fundamental technologies are often born in the university setting, and incubated in small start-up companies (Kahn, 1991).
Starting a company can be a great opportunity to raise the awareness of academic work, and also to have a significant impact on the industry and on patients’ lives. It is a complex process of bringing together people, ideas, money, and business. The start-up environment is a fast-paced, dynamic, and collaborative home for a project, and with the right vision, team, technology, and plan, a start-up company can be highly efficient at creating significant development progress and creating considerable value.
However, we want the reader to understand the risks inherent in starting a company: a relatively small percentage of start-up companies get a product to market (Gompers, 2008), and the effort required can be substantial. Therefore, the decision to spin out one’s research into a company should not be taken lightly.
Many paths can bring a technology or product to market, and many of the functional challenges of patent protection, product design, regulatory approval, reimbursement, and ethical issues are described earlier in this book. These challenges are faced both in established companies and start-ups. However, the culture, pace, politics, risk profile, and potential reward differ between start-up and large company. It is recommended that the biomaterials specialist consider entrepreneurship as one of many potential avenues for developing a successful product.
This chapter will step into the shoes of an entrepreneur planning to start a company. First, we will survey the entrepreneurial ecosystem with a focus on the interconnections between its members and the transfer of resources into the company. After an overview of the start-up process, we will cover the criteria entrepreneurs use to decide which company ideas are worth spinning out, and which ones are better suited to academic exercises or large company projects. We will finish with several tips on entrepreneurial decision making, and how venture capital firms decide which companies to fund.
The fundamental message of this chapter is that academics, entrepreneurs, and investors should carefully choose which companies to start, join or fund. In this chapter, we will develop five criteria for starting a new company. As you read the various sections, keep these criteria in mind, and we will revisit them at the end of the chapter.
Suggested criteria for choosing research projects to spin into a company include the following (Kent Bowen et al., 2004):
1. Is this a high impact area?
a. Clinically high impact (will it help patients?)
b. High impact to potential commercial partners (will it create shareholder value?)
c. Scientifically high impact (is the technology new and important?)
2. Have you published a seminal paper?
3. Have you obtained a protecting patent?
The Entrepreneurial Ecosystem and the Start-Up Process
The creation of a start-up company assumes that a small, focused, and highly motivated team can efficiently develop a new product and that the company can be the appropriate investment vehicle for those involved. In a start-up, inventors of intellectual property, shareholders, employees, and other key players acknowledge that the start-up is the best vehicle for commercializing the technology, as opposed to licensing to a company, for example. This advantage may exist for a number of reasons: for example, universities may lack the facilities or infrastructure to take a project to the next step or large companies may be constrained by their organizational bureaucracy. In other cases, the choice of spinning out a project into a new company is purely financial (Chatterji, 2009).
Although start-up companies lack some of the structural challenges common in universities and large companies, they have their own risks. Start-up companies have a narrow focus, sometimes on a single product or narrow platform, they cannot diversify risks in the ways large companies can. Therefore, if a start-up encounters an enormous setback, with no way to compensate, it may trigger the company’s demise. Start-up companies do fail for reasons beyond anyone’s control, and all parties should understand that although the risks are high, the rewards are great if the company succeeds. The challenge for the start-up company is then to share these risks and rewards in an equitable way between all of its members. Bringing together all of these partners is the first challenge of building a company.
Figure III.2.10.1 summarizes the process of transferring these people and resources into the start-up company, NewCo. In the figure, the four main components of a start-up are color-coded as described below.
FIGURE III.2.10.1 The entrepreneurial ecosystem. A representation of the complex interplay between investors, universities and existing companies in the industry.
The essential components of a biomedical start-up include:
It is the combination of these components that leads to successful companies. When brought together, these raw materials lead to the creation of high value products, as shown in Figure III.2.10.2. The process of bringing them together is a complex and high-risk exercise.
FIGURE III.2.10.2 Inputs to generating innovative life science products.
Each of the pieces is typically legally “transferred” from other organizations to the start-up. The typical organizations in the entrepreneurial ecosystem include:
Figure III.2.10.1 shows the connections between these organizations. At the center of the ecosystem, the start-up must build relationships with the university, the funding agencies, and its corporate partners. As the start-up builds these relationships and negotiates to bring in people, IP, facilities, and capital, a number of decisions are required.
These decisions are made by the shareholders in the company. When a company is incorporated, it becomes a discrete legal entity. Shares of the company, each of which represents ownership of a fraction of the company, are distributed between its owners. The shares have value because the shareholders are entitled to their fraction of the start-up’s future profit. Capital investment (cash), intellectual property rights, and services can all be exchanged for shares. Since the start-up company is private and there is no market where shareholders can sell their shares, it typically sells chunks of shares to equity investors in exchange for a cash investment. This equity investment sets the price of the shares, and gives the company money to begin operating. As the pieces come together, the relationship with each partner is formalized with a contract outlining the specific terms of the relationship. The company exchanges money or shares in exchange for people (labor), technology (IP rights), and facilities.
The following subsections review each of these relationships within the start-up ecosystem. We will first discuss the university (or research hospital), a common source of technologies and scientists. Our discussion of the university will consider the research lab environment, the technology transfer office, and other university resources. Next, we will cover the start-up company itself and its components. Funding agencies will be covered next, as there are many options for funding a start-up company. Finally, we will cover corporate partners and their role in helping build new, innovative companies.
The University (or Hospital)
Universities and/or research hospitals are a site of innovation. New technology, new biomaterials, new devices, and new biological concepts can all provide the motivation and genesis for a new company. As Figure III.2.10.1 shows, several connections exist between the university and the start-up company. Universities play a central role in connecting the other organizations in the ecosystem, and in disseminating knowledge (Rothaermel and Ku, 2007). The primary interface for the start-up and the university is between academic experts who may become founders or advisers to the company and through the licensing of intellectual property. The university’s fundamental strengths are innovation, cutting-edge expertise, and IP generation. Its research labs are often staffed by the brightest innovators in the world who invent intellectual property (“IP”), which the university owns and then transfers to the start-up company. As Figure III.2.10.1 shows, thought leaders interface directly with the start-up company, as well as technology transfer officers.
Innovation Engine: The Research Lab
The research lab is the university’s innovation engine. Many aspects of the university research lab make it the ideal site for fundamental discovery. The university’s research goal is to push the frontiers of scientific and technological discovery. Therefore, researchers are not directly focused on inventing a specific product, but instead can think very creatively about new technologies or the application of technologies to new problems. They can take high risks as part of the learning process. This culture contrasts with the culture inside an early-stage start-up, where specific milestones (set at the beginning) determine the company’s success. The academic lab must create publications, whereas the start-up company must meet very specific stated goals on time.
Culture
The academic culture tends to reward people who enjoy and excel at being the first to communicate a new idea or discovery (Stalcup, 2006). Although the multidisciplinary nature of modern technology and its application to medicine require teams of researchers from diverse backgrounds to work together, ultimately, all academics are required to be the contributing author of numerous top publications. This creates a healthy competition between academics, which speeds academic progress, since multiple labs want to be the first to publish.
Another feature of the academic culture is the unlimited pursuit of intellectual inquiry. There is no limit to how risky a research project could be, in terms of leading to a tangible outcome, as long as it has a high likelihood of leading to academic publications. Because academic research is understood to be a learning process, and fundamental research is high-risk in nature, it is very difficult to put definitive timelines on results in academic research. This is in contrast with development work done in a company setting, which typically has very specific timelines and milestones for completion, but creativity is also very important in small companies.
The culture inside a start-up company is focused on working together to meet milestones. If the whole company does not succeed from one milestone to the next, the company could be shut down. Most key employees in the start-up company are shareholders, and therefore their compensation is tied to the company’s success. The competitor of a start-up is not the person across the lab bench; instead, it’s the clock. In a start-up company, creativity is important, but reaching the next phase of development, and with it the next value milestone, is required. Figure III.2.10.3 illustrates some of the factors that induce the change in culture as a company progress through the development process.
FIGURE III.2.10.3 Activities and cultures through company growth.
What makes a Lab Conducive to Entrepreneurship?
Specific cultural and practical aspects tend to appear in entrepreneurial academic labs. If you are a faculty member running a research lab, you have significant control over the culture in your lab. If you are a student interested in joining an entrepreneurial lab, you might evaluate the lab on its history of the aspects listed below.
1. Hiring researchers with an interest in starting companies, and encouraging them to act on those interests.
2. Solving problems that have impact and could potentially be translated into products, especially in areas where you are willing go against the conventional wisdom.
3. Being willing to work on high-risk problems. The solutions to the problems may take a long time or have a low probability of success; however, if the solution to the problem is very important, it’s worth trying to solve. This can lead to the fundamental discovery and patent, which can be taken to the next step (product development) in a start-up.
4. Encouraging a collaborative environment. The academic process can induce competition. There are other ways to promote a culture of collaboration that will help people think like entrepreneurs. For example, broad projects that require technologies from multiple backgrounds induce people to work together. Focusing diverse teams on important problems is a critical focus.
5. Paying attention to IP early and focusing work in areas where there is room for significant IP filings. Finding areas were a new discovery can lead to a seminal patent will help lead to fundable spin-off companies.
6. Building a good relationship with the technology licensing office at your university (see Figure III.2.10.1).
7. Building relationships with venture capital firms and corporate partners. It is important to understand what problems they are facing, so that when you have an idea that is relevant to those problems, you will know where to turn (see Figure III.2.10.1).
8. Helping to promote entrepreneurship at your university. Many schools encourage faculty and students to participate in entrepreneurship programs, and some offer grants and other support for small translational research projects.
How to Decide when it Makes Sense to Move a Company Out of the Academic Lab
Many factors contribute to the decision of when to move a research project from the academic research lab into a company. As mentioned above, it is typically after fundamental IP has been filed and significant proof of concept has been completed that development work starts in a new company. Before the development work begins, the researcher should ask a number of questions, including the following:
Do you have enough data and confidence?
You will take the plunge into the company either as a full-time employee or as a significant adviser to the company. You will have to be involved in getting funding, recruiting employees and senior management, and making the company move forward. It is your time and energy, your career, and your reputation that you will invest in building this company. It is in no-one’s interest for you to prematurely try to start a company. Therefore, you should wait until you feel confident in taking the leap into the start-up world. This may require extensive interaction with advisers in IP, commercial and/or clinical development, and entrepreneurs, but you should have a strong positive feeling about your venture. To succeed, a company concept takes more than great lab work and great data: it takes a diverse team of great people to build a successful company. It also takes a diverse team of great people to know which companies to build.
Have you created enough value to generate interest from investors?
Equity investors exchange cash for equity in the company. Pre-money valuation is the company’s value immediately before the transaction, and post-money valuation is its value after the transaction. Pre- and post-money valuations are related through the following equation:
The relationship between share price, valuation, and number of shares is:
Sometimes (but not always) share price is set to $1/share at the first venture funding, and therefore pre-money valuation is equal to the number of pre-money shares. Share price can change after each round of venture funding, and at each round of funding the following relationship is valid:
The company’s value increases as the company makes more progress and generates more data. Therefore, it can be to the founders’ advantage to generate as much data as possible using grants before taking an equity investment. There are several benefits to having more data: you will be more confident, possibly making it easier or quicker to raise money, and you will retain more ownership in the company after funding.
What is your IP protection?
NewCo will license IP from the university. Usually, the company must be formed before the license agreement is executed. Sometimes the university technology licensing office will pressure founders to execute a license agreement in an attempt to quickly recoup the cost of the patent application. This is just one of the considerations in the decision of when to incorporate the venture. This is not necessarily the right time to start a company, but it is possible that the technology transfer office may license the IP to another company (having a great relationship with them helps).
What are the funding opportunities for the company?
Without significant funding, it may be pointless to create a virtual company (described in the sidebar), especially if there is significant funding to continue the research in the lab.
Definition of Terms
Founders are generally the thought leaders involved in assembling the vision the company is founded around. Founding a company is a process by which the company becomes legally incorporated. Corporations have limited liability, which protects their shareholders and employees’ assets from legal liability related to the company’s operations.
A virtual company is a company that has no physical assets, facilities, lab space or offices. All of the company’s employees work from home or from their own remote or virtual locations.
Pre-money valuation is a company’s value before it has taken any cash investment. Post-money valuation is a company’s value after a dilutive equity investment. Post-money = pre-money + amount invested. In a dilutive equity investment, investors exchange money in exchange for shares in the company. As the company issues more shares (at a given valuation), the current owners are diluted or own less of the company. Non-dilutive funding comes from sources that do not exchange equity for money, but rather give money for free.
Licensing terms are agreed upon reimbursement for the rights to operate a business in an area covered by the patents a university holds. The terms of an agreement typically include cash payment, equity, and/or royalties.
Due diligence is the investigation of an opportunity as a potential investment. Due diligence is done by investors, entrepreneurs, large companies, and others to determine an investment’s merit. The process usually involves learning about the expected challenges and timeframe for generating a valuable enterprise, the costs associated with the venture, and the expected future value of the investment.
What is your academic grant funding situation?
Because pre-money valuations increase, and the probability of getting venture funding increases with every positive experimental result, it can make sense to continue making progress in the academic lab so long as funding allows and so long as there is no significant pressure to license the IP from the university. There are clear examples of start-up companies that have been started in a virtual mode. This is one potential way to start a company early with a very small investment, and avoid much of the challenge of being diluted by a large investment at a low early-stage valuation. It allows the research scientist to leverage the research dollars raised from grants. One potential drawback to this approach is that universities often issue policies restricting research sponsorship from flowing into labs where the principal investor is a founder or shareholder of the sponsoring company.
Technology Transfer Office
In the previous section, we discussed that the purpose of the university lab is to innovate and to publish and patent its innovation. The technology transfer office is the central clearinghouse for licensing IP from the university.
Chapter III.2.4 in this book reviews the patent process itself. The transfer of IP rights to a new company is an important step, and is outlined in Figure III.2.10.4. University employees and faculty are usually required to assign the IP rights to the university for any invention where they used university resources. They are required to document an invention through a standard disclosure (Jensen et al., 2003), which is a legal document that describes the invention and becomes the basis of a provisional patent. The submission of a disclosure triggers an internal process by which the technology transfer office evaluates the invention to determine whether it merits investing in patent protection. There is a fairly extensive literature on evaluating patents (Allison et al., 2004). Case agents are usually assigned to a particular project and/or faculty member, and when a decision is made to move forward with an application, they will help manage the process of hiring the appropriate legal counsel to draft the application.
FIGURE III.2.10.4 The flow of resources and intellectual property between inventors, universities and startup companies.
The same patent agent will typically be heavily involved in the process of licensing the IP to a start-up company that will be commercializing the technology, as shown in Figure III.2.10.4. Sometimes there is a licensing agent (a different person form the patent agent) who manages the licensing process. In some cases, technology transfer offices also have other resources for entrepreneurs. These can include investing venture or seed funds, business plan competitions, translational research grants for researchers, and so forth.
Patents
As described earlier in this book, the Bayh-Dole Act of 1980 gave universities the opportunity to retain IP for government grant funded research. As owners of the IP, universities decide to whom they will license this IP, and under what terms (Lin and Kulatilaka, 2006; Macho-Stadler et al., 2007). When a university licenses a patent to a company, the company and the university then enter a partnership where the university typically retains the ownership of the patent, but grants the company permission to develop and sell product(s) covered by the particular patents being licensed. The company and or the university can usually enforce the IP protection rights against another organization if that organization is infringing on its patent’s rights by developing or selling a product covered under the patent.
Sometimes competitive situations arise where more than one group is interested in licensing a particular patent. Large and small companies can both have an interest in the same IP, so entrepreneurs can find themselves competing with large, established companies for IP rights. Some universities consider the opinions of the inventors, and rely on them to help determine which organization would be the best partner for the university. Often, the small company interested in licensing the technology is being founded by faculty or students involved in inventing the technology, which adds an additional layer to the university’s decision-making. One factor that favors the academic founder is that many universities have identified the process of entrepreneurship as an important part of their mission, as well as being very lucrative (Nelson, 2001; Owen-Smith and Powell, 2003). Sometimes universities believe that some technologies are better suited to licensing to large companies, and although generating revenue is not the university’s mission, licensing agreements with large companies can bring in large amounts of cash quickly.
Licensing terms for a given industry or a given university are not standardized (Thursby et al., 2001). When dealing with a new start-up company, the university will typically propose being compensated with equity in the company (in addition to cash). This introduces a component of risk on the university’s part, since the equity will only have any real value if the company succeeds. However, if the company is very successful, the university will share in the rewards.
The university is not interested in owning a controlling stake in the company; rather, it wants to recoup the financial cost of pursuing patent applications for a number of technologies. Successful IP licenses pay for a large number of patents that are not lucrative; therefore, the university needs to generate enough revenue to cover the costs of ongoing IP submissions. The university may also seek royalties as a percentage of revenue (or profit) from selling the product. This ensures that the university will also share in the proceeds if the company succeeds from a revenue standpoint.
In addition to IP, many university faculty and students are involved with start-up companies either as employees, entrepreneurs or advisers. These individuals can benefit significantly from their activities with the start-up company. Although entrepreneurial and industrial experience is rarely seen as supporting an associate professor’s case for tenure, many universities look favorably on faculty who are actively involved in building great companies. These faculties are often limited by a conflict-of-interest agreement that they must sign when they initiate their employment at the university. The inherent conflict-of-interest results from academic investigators potentially becoming biased in their scientific work, because they have a financial interest in the results. This is particularly relevant in the case of human clinical trials, where a single researcher could directly influence (even if subconsciously) the selection of individuals. For this reason, academics who are company shareholders (and therefore have a financial interest in the company) are sometimes not allowed to have active operational collaborations between their academic labs and the company (Bagley and Dauchy, 2002).
Venture Groups/Arms
Many universities facilitate company creation and technology transfer by operating an entrepreneurship center, venture group or a special center as part of the technology transfer. In any case, this office advises faculty and the technology transfer officers on the array of options for licensing the technology and many start-up issues, like hiring a team, finding lab space, raising money, and the like. In some cases, this group has the ability to invest a small amount of money in the new company on behalf of the university. This process has the effect of financially aligning the university with both IP ownership and equity ownership.
Alumni Networks
Most universities keep records of their alumni for fundraising purposes. Often, the most successful alumni are the most likely to give large gifts, as well as the most likely to be interested in providing mentorship to new companies spinning out of the university. Your alumni office may be willing to share that information with budding entrepreneurs. This can be a great way to find experts with complementary backgrounds to your own, especially those with experience building companies.
Some universities have official mentorship programs designed to provide specialized advice to entrepreneurs at the university. These groups try to retain successful entrepreneurs who typically have good intentions. Within the context of the university system, mentors typically have noble intentions; however, there can be an occasional experience with a “mentor” who is completely self-interested and trying to hijack a new company concept. This should not deter you from working with the alumni from your institution; however, you should use good judgment when interacting with potential mentors, regardless of when or how you meet them.
Business Plan Competitions
Business plan competitions have enormously increased the awareness and interest in student entrepreneurship at many universities. These competitions help motivate and mobilize student teams around exciting new company concepts. These business plan competitions provide prize money and support for moving a company concept forward. Perhaps most importantly, they provide a forum for company builders to meet with other entrepreneurs and to bounce their ideas off other teams in a very non-threatening and supportive environment. Often, the prize money these organizations award is not significant enough to build a company; however, there are many other benefits to competing in a business plan competition, such as great publicity, visibility to potential investors, and free mentorship. If your venture would benefit from publicity, business plan competitions typically have great relationships with the media, and often set up interviews for print, radio or video news with their finalists’ teams. Additionally, the finalists and winners of a business plan competition are often local celebrities on campus, which can help significantly in the recruiting process, and also in raising visibility within the university system and the technology transfer office.
Classes
Many schools of engineering, science, and management offer classes in entrepreneurship, business plan writing, entrepreneurial finance, and venture capital. All of these classes can be extremely useful in helping students understand and set expectations for working with investors and entrepreneurs.
The Start-Up Company
The company is the central entity in the start-up process. Referring back to Figure III.2.10.1, there are many components to a successful start-up company. All of these pieces are necessary, and they must all work together. The founders must not underestimate the challenges of building the company: they must overcome significant hurdles in the process of putting the company together. Again, from Figure III.2.10.1, the main components of a start-up company are people, IP, capital, and physical assets.
People
People are the most important component of the start-up company. Many investors and academics will jokingly say, “I’d rather back an A team with a B idea than a B team with an A idea.” A great entrepreneurial team will unselfishly work hard, work together, and be completely honest with itself about where the company is going. A great team will adjust the strategy and vision of the company as needed. Every start-up will encounter unexpected hurdles, and it will be up to the team to creatively overcome them.
Entrepreneurs
Entrepreneurs are the people who pull together the company concept in the beginning. As depicted in Figure III.2.10.1, entrepreneurs can come from universities, from venture capital firms or be unaffiliated. The entrepreneur is a project manager, cheerleader, and generally the company’s leader. As you can imagine, the goal of the entrepreneur is to create value and to sell that value to investors, employees, and collaborators. Being a good salesperson is a crucial skill for the entrepreneur.
Although entrepreneurs can come from anywhere, typically they are not the inventors of a technology; rather, they meet the inventors through their networks and work closely with them to generate companies. Some academics have friends who are entrepreneurs who they work with over and over again, and other serial entrepreneurs work with different scientific founders. Serial entrepreneurs are professionals who start company after company. They generally have a better track record than first-time entrepreneurs (Gompers, 2008). Many research studies have analyzed factors that make entrepreneurs successful. Some of the most important characteristics include social skills (Baron and Markman, 2000), personal networking (Witt, 2004), and motivation (Buttner and Moore, 1997).
To evaluate a new company idea, an entrepreneur will undertake a “due diligence” process of analyzing the opportunity. The entrepreneur is trying to convince himself or herself that the opportunity is worth taking, and that it is worth investing time into building the company. This process typically involves asking experts to help evaluate the technology, market opportunity, appetite for funding, and general excitement about the company. This process is somewhat similar to the due diligence process a venture capitalist would use to evaluate an opportunity for funding. The entrepreneur evaluates the opportunity for its ability to raise funding and succeed.
If you are an academic or a student who is interested in playing the role of the entrepreneur, you should certainly take an objective view of the project and ask yourself whether you would be passionate about the idea if it were not your own. When you have invested so much in an idea already, it can be difficult to objectively analyze the opportunity.
Building a successful company takes hard work on the part of a number of people. The team is very important, and typically includes experts from business, technology, and medicine. One of the key aspects to a successful start-up is the seamless collaboration between business and technical leaders. The general culture in the company has a great effect on the organization’s efficiency. Generating great cultures is a non-trivial task, and many entrepreneurs fail because they do not have the appropriate temperament. Many books have been written about how managers can and should interact with each other to form great cultures (Kotter and Heskett, 1992; Collins, 2001; Flamholtz, 2001; Johnson and Phillips, 2003).
Founders
Founders are individuals who are involved in the company at its inception. They can be academic experts who lend technical credibility, help recruit talented individuals to the company or invent the technology, or who are entrepreneurs. Ultimately, these experts typically will join the company’s scientific advisory board, and in some cases the board of directors. Sometimes, they can be full-time company employees, but they typically maintain an academic or clinical appointment to maintain their professional credibility.
Management Team
The management team is the group that makes strategic operational decisions. The typical management team is comprised of a Chief Executive Officer (“CEO”), a Chief Medical Officer (“CMO”), a Chief Scientific Officer (“CSO”), a Chief Operating Officer (“COO”), and others. In the early days of a start-up company, all of these positions may not be filled. Management teams are flexible, and are designed to cover all the needed skill-sets. Collectively, this team should be an expert in every relevant area. Often the recruitment of the full-time management team will be coordinated with the venture group backing the company, and will not be the responsibility of the founding academics. The entrepreneur may or may not become a part of the management team as the company moves forward.
Board of Directors
The board of directors (“BOD”) typically is responsible for choosing the company’s strategic direction. This group of people has specific legal responsibilities, and is required to provide governance to the company (Bagley and Dauchy, 2002). In addition to their official legal requirements, the BOD usually represents the company’s investors and advises the management team on how to move forward in the investors’ best interest. The board usually includes the CEO and/or president of the company, as well as representatives of the investors, and often a representative of the founders and an independent representative who is typically an expert in the industry and well-connected with other groups, especially with established companies that may become interested in acquiring the new start-up.
Employees
Employees are perhaps the most important component of the start-up. They perform the company’s operations and support the executive management team in executing the plan developed with the board. Typically, employees can come from labs that invented the key technology or collaborating labs. Having world-renowned founders and a top management team immensely helps in recruiting great employees. There are several resources on recruiting great employees and building effective cultures (Kotter and Heskett, 1992; Collins, 2001).
Advisers
Start-up companies typically will hire any number of industry experts to help them operate. One of the challenges with an early-stage company is that there are limitations to the number of full-time employees the company can afford; however, a large number of job functions need to be completed. Many of the job functions required for operating an early-stage company only require a fraction of the resources of a full-time employee. In particular, some of the technology-agnostic functions like accounting or financial governance do not require a full-time employee. In this case, it is common to have a part-time employee serve in a flexible capacity on an hourly basis.
Ideas and Intellectual Property
Intellectual property is very important for the new company. It is often the only “property” the NewCo owns. Most start-ups don’t employ in-house IP attorneys at a very early stage. Typically, their IP advice comes from an external counsel, who may be compensated with options or shares of equity in the company instead of with cash. This is especially common for early-stage companies before they have raised capital. Detailed analysis of IP is covered in an earlier chapter in this book, as well as in the section on technology transfer.
Although the IP licensed from the university is typically the basis for the company, additional IP is generated inside the company. Developing a strategy for IP development is an important activity of the management team. IP is especially important in medical device companies because there are many theoretical ways to solve most medical problems. Having a strong IP portfolio can be key to protecting the start-up’s market. The selection of IP experts is key to understanding the competitive landscape, as well as pushing the company’s own patent applications.
Physical Resources
Physical resources are required for the company to operate. These can be in the form of offices, lab space, assets, equipment, and the like. As mentioned earlier in this section, early-stage companies can often operate in a virtual fashion and collaborate with the inventor’s labs within the university. Although this process can be a delicate balancing act of avoiding and managing potential conflicts of interest, it is often more appropriate to minimize the requirements for physical resources by operating the company out of a home office, for example. However, most universities have strict policies on IP ownership, and if a member of the university generates an invention, idea or another form of IP using any university resources, then the university has a claim to (at least partial) ownership of that IP.
Capital
There are many sources of capital, and raising capital is a very complex process. The main considerations are how much capital to raise, where to raise it from, and at what valuation. Multiple sources of capital are described in detail in the next section, but in this section we will cover the strategic decisions a company must make to meet its fundraising needs.
Early-stage capital investment is very important for the company, and the management team must constantly operate the company in the most capital-efficient way. The company must raise enough money to operate and grow comfortably, but it must not raise or spend more money than required, since this leads to unneeded dilution.
There is a clear trade-off between raising a large and a small amount of money. If the company intends to grow rapidly, it needs to raise a significant amount of money. Many finance textbooks and courses cover the basics of corporate/entrepreneurial finance (Smith and Smith, 2000; Denis, 2004; Brealey et al., 2006). Ultimately, there is no specific answer to how fast a company should grow, and it is a strategic decision for the management team and the BOD. From the perspective of the founders, dilution is a major trade-off.
The next strategic question is determining the source from which the start-up should raise money. The main sources of funding are grants, venture capital, and corporate partnerships.
Grants
Grants are a great source of capital for the company, and a number of government and non-government grant agencies are described in the “Sources of Capital” section. Because grant funding is not exchanged for equity, it is non-dilutive and is therefore very attractive.
Grant writing can be a very time-consuming process. The time and effort put into grant writing can pay off if the grant is awarded. However, grants are not awarded to the majority of grant applicants. Therefore, when a small company is thinking strategically about raising money, it must also consider that the time, energy, and resources spent preparing applications for the grant process may not pay off in the long run. The company must find the right balance between risk-taking and stability.
An additional feature of grant funding is that the oversight is largely only financial in nature. Grant money is typically not managed by a person representing the interests of the grant who sits on the BOD. This is completely unique when compared to capital raised through the sale of equity to investors. This stems from the fact that private investors have purchased equity for the main purpose of generating return on capital during a given duration.
Venture Capital
Venture capital is the most common source of funding for start-ups. When choosing whether to work with a venture capital firm, you should consider a number of things. The potential pros of building a company with a venture capital firm include:
1. The probability of the company’s success increases (experienced company builders get involved and bring extensive networks to the company).
2. Things will move faster in the direction of financial return.
3. It is typically easier to recruit senior management to the company after the validation of significant venture funding, especially from a firm with a good track record.
But the potential cons of building a company with a venture capital firm include:
1. There will be substantial dilution for the founder(s) and entrepreneur(s).
2. Founders will give up substantial control in corporate decision-making.
Ultimately, the entrepreneur(s) must see the venture capitalists as true partners in the business, and this is easiest when they have a strong relationship. Venture capital firms and angels almost always contribute to building the company. This can be through their position on the company’s board or, in some cases, by contributing entrepreneurial or operational capabilities. More experienced investors with better track records have a higher probability of taking a start-up company to a successful exit (Gompers, 2008).
Talking to Venture Capital Firms
Venture capital firms have a significant preference for companies founded or recommended by someone in their network. Therefore, networking is very important. If you are interested in potentially starting a company and raising venture money in the future, it makes sense to build relationships with several venture capital firms in your area (both of expertise and geography). Firms are always in need of expertise for evaluating new investment opportunities, and often hire experts in various fields to help them understand opportunities. If you are actively looking for venture funding but do not have an existing network in the venture industry, it likely makes sense to find an entrepreneur (either an academic or a business professional) who has a successful track record of building companies and raising venture capital. Ideally, you’ll find an entrepreneur with expertise in building and selling successful companies.
Important Differentiating Factors between Venture Firms
Many factors define the venture firms you may consider working with.
SIZE Large firms tend to want to do bigger deals, and may be interested in investing larger amounts over a longer period of the company’s lifetime. Their downside is that their partners may be very busy or focused on other later-stage companies in their portfolio and have less time to work with early-stage investment.
VALUATION Valuation is the often the largest point of contention or negotiation between start-up and venture capitalists. The entrepreneur should remember that valuation is important, and stock ownership is only relevant if the company is ultimately successful. Building a good working relationship with your investors and board of advisers is more important from this standpoint than the actual valuation.
The structure of the deal and terms on the term sheet are just as important as the actual valuation (Wilmerding, 2003; Gold et al., 2005). Many venture capital firms attempt to add terms that give them preferential status over the entrepreneurs and employees of the company.
EXPERIENCE Experienced investors bring more to a deal than money. They have years of experience building companies, and they will likely have a better context for setting the direction of the company than inexperienced investors. Many successful entrepreneurs start venture capital firms, and individuals as well as firms have great reputations. Venture capital funding offers are three times more likely to be accepted when they come from a firm with a strong reputation. In one study these respected firms often get a 10 to 14% discount on equity (Hsu, 2004).
WILLINGNESS TO HELP BUILD THE COMPANY Some venture capital firms will help identify business leaders and entrepreneurs to join the company or join the company themselves.
When you begin speaking with venture capital investors, don’t be alarmed if things move slowly. If and when you have developed a relationship with venture capitalists and you would like to discuss funding opportunities, your first challenge will be to piqué their interest to convince them to initiate the due diligence process (Dooley and Dooley, 2003). This process will take place over a timeframe that is mutually agreed upon by you and the venture capitalist. The venture capitalist will ask you a number of questions over the course of weeks or months in a process somewhat analogous to an extended job interview. At the end of the process, you may get an “offer” in the form of a term sheet that outlines the valuation and terms for potential investment or the venture capitalist may decide to pass on the investment. In either case, you will have learned a lot about what it takes to build a company, and you can apply this experience to the next venture capitalist interaction you have.
Sources of Capital
The previous section reviewed the funding scenario from the perspective of the start-up’s strategic decision-making process. This section will review more specific information about each of the sources of capital: grants; venture capital; and corporate partnerships. Figure III.2.10.1 shows the various types of funding that can flow into a start-up company. Each of these sources has its own unique challenges and opportunities. Below is a review of each of these sources.
Grants
Grants, by definition, are money that is given to an organization for a specific project related to an interest of the grant agency. Often grant money comes from government sources, and in addition to academic funding, many government agencies have grant programs available for early start-up research efforts inside companies. The purpose of these grants is to improve the competitiveness of the local or national economy, to support the generation of new and better medical technologies, and to develop new companies.
Perhaps the most common entrepreneurial grants issued by the government are the US Small Business Administration’s Small Business Innovation Research (SBIR) grant and the Small Business Technology Transfer Program (STTR). These grants are typically awarded to small businesses developing technology in an area that is important for national health, national security or the like. These grants are awarded in escalating phases. Phase one feasibility grants are typically intended for the initial phases of projects, and are awarded for a 12-month period in an amount up to $100,000. These grants are intended to allow the company to demonstrate a proof of principle,and generate initial data on their concept. Phase two grants allow the company to expand on the data generated in the phase one grant, and they are awarded for up to 24 months and in an amount ranging from $500,000 to $750,000. The final phase three grants are typically funded outside the SBIR, and involve the commercialization of the technology. Solicitations for these SBIR grants are posted on several government and other websites available through http://www.sbir.gov. These grants are offered by the Department of Defense, Department of Energy, National Institutes of Health, National Science Foundation, and National Cancer Institute, among other government organizations.
Several firms offer consulting services to help write and/or advise start-ups in the strategic process of applying for SBIR grants. If the entrepreneur has limited experience writing grant applications, it may be advantageous to hire an experienced leader to supervise the grant writing process. Studies of SBIR recipients have concluded that SBIR awardees are more successful when the academic principal investors are involved in the company (Toole and Czarnitzki, 2007).
In some cases, non-government organizations offer grants. Examples of philanthropic organizations include the Bill & Melinda Gates Foundation, the Carnegie Foundation for the Advancement of Teaching, the Kauffman Foundation, the Ford Foundation, and others. Many larger corporations have extensive corporate foundations that donate money to causes in society’s best interests.
Venture Capital Firms and Business Angels
In 2008, there were 382 venture capital investments in medical devices and equipment companies, which totaled $3.4 billion. Therefore, the average venture investment in 2008 was $9 million (Money Tree, 2009). The collective investment of business angels is harder to track, but a recent report predicts that angel investing in US medical devices and equipment was $3.1 billion in 2007 (Sohl, 2008).
Venture capital firms are usually partnerships that raise an investment fund from a variety of investors called limited partners. Sources of funding for venture firms are wealthy individuals, institutional investors, endowments, and the general partners (individuals) in the fund themselves. Venture capital firms raise money with the intent of returning the investment plus a substantial return to their investors. Financial incentives are used to ensure motivation, and usually there are incentives to build companies that have a high probability of “exit.” A successful exit is the sale of the company for a significant multiple of the amount invested, and this usually means the company must be put together quickly and meet a number of milestones that increase its value moving toward acquisition or going public. This approach may (or may not) be in the entrepreneur’s best interest. Often, when start-up companies take a significant equity investment, the company’s founders lose financial control of the company through dilution. This may be the best option for the entrepreneur, but some early-stage company builders do not like to relinquish control, since they have some personal connection to the company they have built.
Corporate Partners
Many large companies are involved in start-ups, and this is becoming a more popular, particularly for medical device and pharmaceutical companies who are struggling to gain access to new drugs or devices as their pipelines are not full. Public markets follow economic trends, and at the time of press were mostly out of the picture, acquisitions are currently the primary exit possibility for start-up companies. Therefore, building a relationship with large companies is of utmost importance for the successful start-up company, which should focus on making itself an attractive acquisition target.
Medical device, pharmaceutical, and biotech companies have developed sponsored research programs with universities to help academics fund translational research (Business Wire, 2009). This approach usually involves research money flowing into the university similar to a grant, but it is usually accompanied with a blanket license agreement that grants a license in any resulting IP to the sponsoring company. Therefore, in some ways, this approach is not compatible with starting a new company.
Another model that has also become interesting to venture investors is early-stage collaborations with large companies. This model theoretically allows the technology to spin into a start-up company, yet creates a relationship with a potential acquirer early to maximize the probability of acquisition by signing an option agreement on the company. Admittedly, this strategy can limit upside for the start-up company if it is wildly successful, but it can also help keep management focused on the company’s operation, since it will not have to focus on finding an acquisition partner. In addition, it helps diversify the financial risk, as well as leverage the large company’s scientific resources.
The start-up company benefits from working with a large company because publically announced collaborations can bring money, credibility, and expertise into the company. These aspects of doing a collaboration deal lead to value creation and ultimately liquidity.
As a start-up company is courting potential buyout partners, there is a trade-off in timing analogous to the beginning of the company. As the start-up operates further it generates higher value, which should be reflected in the buyout price. However, as more capital is used, current shareholders take on significantly more dilution.
Even in the absence of an official collaboration with a large company, close interactions and discussion about technologies can help early-stage companies. At a minimum, close interactions with large companies can help any start-up management team build the company with the maximum probability of acquisition.
Building a Successful Start-Up
As mentioned throughout the text, many things need to fall in place for a start-up company to move forward. Ultimately, only you can define what success means for your start-up venture. However, the authors have assembled some general guidelines based on past experience of building companies that have received funding.
This section reviews some of our thinking on the key questions of why, how, when, and which company to start. Many potential entrepreneurs blindly fall in love with an idea or stick to an idea just because it was their idea, pushing it forward passionately. But in the end, the company’s projects do not reach the market. In the pharmaceutical world, there is always the risk of not clearing clinical trials, which will typically signal the end is near for the company. On the other hand, many company concepts fail for other reasons. Some common stumbling blocks for early-stage companies include:
1. Wrong management (CEO, CSO or others make poor operational decisions).
3. Missing technical milestones.
Many of these mistakes could have been avoided, or at the very least, red flags should have alerted the start-up team that there were substantial problems with the concept that should have come up during the due diligence process.
The following sections provide a guideline for the potential academic entrepreneur to do his own due diligence, and to be honest about the opportunity before he or she jumps in blindly. Indeed, great company concepts are not that common, and the process for self-evaluation should be just as rigorous as the process the venture capitalist carries out.
The potential entrepreneur should spend significant time reflecting on himself or herself, as well as the questions posed here. Often, many entrepreneurs gloss over this part of the process. They suffer from being biased toward their own idea, sometimes so much that they are blinded to the rest of the landscape. In fact, sometimes other opportunities are there but go unnoticed, because the entrepreneur is too focused on his or her own work.
Why Start a Company?
Starting a new company is not something that should be taken lightly. It is a lot of hard work. It takes a lot from the people involved, and there is significant risk involved with pushing forward in a given entrepreneurial area. As an entrepreneur or an employee of an early-stage company, you will need to roll up your sleeves and get your hands dirty. You will most likely do everything from sweep the floor to cashing the big checks from time to time. The start-up mentality is very different from that in the corporate or academic world. You should ask yourself whether you are truly passionate about the idea you are considering building a company around, and then ask yourself why you are passionate about it.
Choosing the Right Company Concept
Many academic scientists are interested in building companies. The reader might ask, what will make the difference between a successful start-up and one that fails? No formula can guarantee success in a start-up company. However, the authors have developed a list of criteria that can form a general guideline for research projects that have high potential to raise money and ultimately become successful companies (Kent Bowen et al., 2004).
Doing Your Own Due Diligence to Prepare for the Venture Capitalist Pitch
The due diligence process has been defined over and over again by the venture capital industry. Generally speaking, this is the process of getting comfortable contributing a significant investment. In the case of the entrepreneur, the investment is his or her own blood, sweat, and tears. In determining whether and what to invest, venture capital firms use several criteria, and there are several books, websites, and publications on venture capital due diligence (Camp, 2002; Gladstone and Gladstone, 2002). Here, we will focus on the issues of specific relevance to the technical evaluation of an early-stage biomedical company concept.
This list of potential due diligence questions will sum up most of the content of this chapter in a simple table that the reader can easily refer back to in the future. The answers to these questions are typically summarized in a presentation that is delivered to the venture capital group to spark its interest in doing its own due diligence.
1. Team: Is the academic founding team outstanding? When thinking about all the potential top academic founders in the world, are a substantial number of very top people involved as founders of this company? This is important because it gives the company confidence that this will be the leading company in the field. Has the entrepreneur or have the founders done a good job of assembling the top scientific team in the area? Have you done background checks on the other founders?
Is there an extraordinary management team in place or can one be recruited? One of the largest stumbling blocks for an early-stage company is an inexperienced management team that demands retention of control of the company. If the company’s intention is to obtain significant funding, it will need to have seasoned management with a serious track record of success.
2. Technology: This includes the existing technology and the technology plan that could be laid out for the company. Is there a high probability of success? Has the company thought through a research and development path for the next several years? What are the milestones along the way? How much will it cost to reach each of those milestones? How long will it take, and how much will it cost to get to clinical validation of the product? Are there any simple, cheap experiments that could significantly improve the probability of success? Is the technology in an area that is of critical importance to large companies that may acquire the company in the future?
3. Financial: How will this project appear to a potential investor? What is a reasonable pre-money valuation? Given the pre-money valuation, funding requirements, and expected exit options, is it possible to generate appropriate venture capital returns?
4. Market: What is the overall market for the product or concept? What are the commercial issues with respect to this market? Who are the competitors, and how will the new product be positioned relative to the existing products? Who are likely acquirers, and have they done similar deals in the past? What has the value of these deals been?
5. IP: Is the IP strong enough to build a company? Have you asked an independent IP attorney to review the IP? Is there freedom to operate given the other IP in the space?
Conclusions
We hope to have made a positive impact on our readers by giving them a better sense of the basic mechanics of starting a company and what some of the challenges would be. We started the chapter by giving a basic overview of the company-building process, and explained where the pieces of a start-up company come from and how they are transferred into the new company. Next, we analyzed how to distinguish between an opportunity that may represent a successful company and one that may be less attractive.
Together with the other information in this book, and perhaps some personal interaction with business and legal advisers, readers can better evaluate the start-up process as something that makes sense to pursue for their technology.
Case Study The Drug Eluting Stent Industry
Innovation in the stent industry exemplifies many of the concepts explored in this chapter. The market forces around the stent market combined with innovation in many start-ups led to an explosion in the market and a revolution in the way patients were treated.
The Clinical Need
Coronary artery disease occurs when atherosclerotic plaques clog the arteries that supply the heart. It affects about 13 million Americans, and this number has grown significantly due to an aging population, obesity, lack of exercise, and other factors. In the 1980s the surgical option for severe coronary artery disease was bypass surgery, with the non-surgical option of balloon angioplasty. Balloon angioplasty has grown in popularity, since it is much cheaper and less invasive. However, balloon angioplasty is often accompanied by restenosis and reclosing of the artery in 30–40% of cases within six months of the procedure.
Bare Metal Stents
To address the high recurrence of arterial narrowing and blockage, bare metal stents were introduced. Deployed with balloon angioplasty, stents physically limit an artery’s ability to reclose after the procedure. However, even with a stent in place many arteries developed scar tissue and reconstrict. With the market demanding solutions offering better quality of life, local delivery, and more cost efficiency, the first use of the coronary stent (Palmaz) started in the early 1990s. Others joined the market, and by the early 2000s the number of stent procedures had reached one million. This was a revolution in the way coronary artery disease was treated. However, there were still over 150,000 patients in the US requiring reprocedure due to restenosis.
Drug Eluting Stents
The first commercially available drug eluting stent was the Cypher stent from Johnson and Johnson. These stents combined the mechanical support of keeping the artery open plus the ability to locally deliver restenosis-preventing drugs released directly from the stent. The use of drug eluting stents decreased restenosis significantly to below 10%. Because outcomes were increased significantly, drug eluting stents were quickly adopted and used in hospitals.
Development of Technology in Small Companies
Cordis, which was founded in 1957 in a garage in Miami, had retained the culture of a small and innovative company. Several technologies came out of this company including angioplasty catheters, pacemakers, and ultimately stents. It was the combination of several product/technologies developed in Cordis, Biosense, and other start-ups that enabled the image guided drug eluting stent market to grow so quickly. This is a common practice in the medical device world; many new technologies are developed at small innovative companies, and then acquired by large companies to fill their product pipelines.
Reimbursement and Adoption
With any new medical device, reimbursement is very important. Medical procedures are reimbursed by Medicare and/or private healthcare providers (insurance companies). In the case of drug eluting stents, cost was very high. Cypher drug eluting stents sold for $3195 at their introduction. Medicare, for the first time in history, announced its reimbursement level for drug eluting stents before FDA approval was complete. The cost increase for using a drug eluting stent instead of a bare metal stent is approximately $2800. This cost is associated with the increased cost of the stent, and the cost of additional blood thinning drugs (Plavix for six months). Medicare decided to increase the reimbursement for the procedure by only $1800; therefore, hospitals were forced to absorb the extra cost of the procedure. Several studies have found the stents to be useful in terms of outcome, but their cost effectiveness is still debated.
Additional reading on the development of the drug eluting stent market, as well as statistics from this case study can be found in Currie and Arundine, 2005; Denend and Zenios, 2006; Ofek and Wickersham, 2008.
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