Curtis Smolar, Partner, Fox Rothschild LLP

1. © 2014 Fox Rothschild
Curtis E. Smolar, Esq.
Fox Rothschild LLP
Raising Capital for MedTech Companies

2. Raising Capital
•Why should you raise capital?
•From whom do you want to raise capital?
•In what form – equity or debt?

3. Why Do You Want to Raise Capital?
•Med Tech product costs are particularly high.
–MedTech R&D is extremely costly.
–Cost of Goods also high.
•Marketing products can be particularly costly due to regulatory and other concerns.
•Scaling is expensive and can by filled with risk.

4. Overview of Med Tech space
The opportunity

5. The Market Size
•Medical Devices
–U.S. exports of medical devices in key product categories identified by the Department of Commerce (DOC) exceeded $44 billion in 2012. That’s more than a 7 percent increase from the previous year. Source: Selectusa.commerce.gov.
–Market Size: The U.S. market size is approximately $110 billion, and it is expected to reach $133 billion by 2016.
–The U.S. market value represented about 38 percent of the global medical device market in 2012.

6. The Companies
•There are more than 6,500 medical device companies in the U.S., mostly small and medium-sized enterprises (SMEs).
•More than 80 percent of medical device companies have fewer than 50 employees and many (notably innovative start-up companies) have little or no sales revenue.

7. Where Are They Located?
•Medical device companies are located throughout the country, but are mainly concentrated in regions known for other high-technology industries, such as microelectronics and biotechnology.
•The states with the highest number of medical device companies include California, Florida, Georgia, Pennsylvania, Illinois, Massachusetts, Michigan, Minnesota and New York.
•Other states with significant sector employment include Texas, Washington and Wisconsin. Source: U.S. Dept. of Commerce.

8. Different Ways to Raise Capital
•TRADITIONAL WAY: VC
•NEW WAYS
–Angel investors
–Public Solicitation under 506(c)

9. TRADITIONAL ROUTE: VC
•Venture Capital
–What is it?
–What do they invest in?
–What is benefit/drawback?

10. Unique Aspects of Medical Devices and Lifesciences
•Shorter product lifecycles;
•Highly litigious IP environment;
•Regulatory barriers; International markets; and
•Affordable Care Act creates new barriers for what Payor and Providers Want.

11. What is Venture Capital
•Venture Capital (“VC”) firms are made up (generally) of General Partners who run the fund;
•Limited Partners (read: wealthy individuals, pension funds, etc.) who invest in the fund;
•VC Firms have a portfolios, such as Internet companies that might be going public, and life science companies.
•Good source of Medical Device Venture Capital firms (http://www.mddionline.com/links/venture)

12. Where (in the Human Body) Venture Capital Is Going
•Biggest increases in Eyes & Ears
•Heart remains strong
(WSJ 9/15/14 (http://online.wsj.com/articles/where-in-the-human-body-venture-capital-is-going- 1410724817))

13. Length of Fund
•Many funds have an anticipated liquidation (“maturity”) date; that is, they usually expect/demand a return on investment within 7 years;
•LP Agreements require that they pay back the investment if it has not returned by this maturity date.
•VCs are paid management fees, plus they take a carry interest of approx 20% (first dibs on profits);
•VCs look for huge ROIs – usually 5X.

14. How VC firm Decideds to Invest?
•The company starts up and needs $$ to grow;
•The company goes to VCs with a business plan showing what the company does and what they think will happen over time;
•How company will grow, increases in revenue, Intellectual property, company team, cost of deployment, etc.;
•If a VC firm decides to invest it gets something in return;
•Should go to VC that specializes in the space the company is in.

15. What will VCs Want in Return?
•VCs take significant equity ownership in the firm – up to 40% or more
•Preferred stock usually includes the following rights:
–board seats
–voting rights
–information rights
–liquidity preferences (take back their investment instead of – or in addition to – converting to common stock at an exit).

16. Typical VC Investment Terms
•Terms included liquidity preferences multiple times the size of their investment.
•Preferred shares that not only converted but also participated in the proceeds (doubling the size of their payoff) (participating preferreds).
•Board seats to keep a close eye on matters and influence executive decision making, information rights that surpassed other stakeholders and often placed an administrative burden on the executives, voting rights to veto any corporate event that they perceived as harmful to their interests.

17. Typical VC Investment Terms (continued)
•Other rights that had a direct, material, tangible, powerful influence on the future prospect of the startup’s survival, including, usually, the right to drop all support of a startup if it was not close enough to liquidity upon nearing the fund’s 7-10 year maturity date.
*** Although some “rock star” startups could demand more friendly financing terms, most startups felt fortunate to be funded, even with these costs.

18. Restrictions on VCs
•VC’s have requirements driven by their limited partners (those are the people that write the checks and create the funds).
•The investors want their money back within the life of the fund.
•This creates a requirement that there be liquidity preferences and other onerous terms for the company.
***These restrictions make sense if you look at how Venture Capital firms work.

19. What Happens When VC invests?
•When a VC invests, it is based on a pre-money valuation;
•When the money goes in, it creates a “post money valuation.”
•The shares granted to the VCs can be from 10-50% of the company depending on what the company needs and can negotiate;
•The previous investors are very often diluted. This means that the VCs will get 50% of shares of company (usually which have to be issued) and the previous shareholders own less.

20. Stock for VC Investment
•First the VCs will want a lot of the shares of the company;
•The investment will often be based on the value of the shares before the VCs invest the money, this is called “pre-money valuation.”
•Often VCs will want better stock then the stock owned, for example preferred shares which may have better voting rights;
•They will also want money back before everyone else in what is called a “liquidation preference.” This means if you get sold, they may get their money back plus a multiplier based on their investment.

21. From Meeting to Funding
•Startups were directed towards Venture Capital firms.
•To the extent that the Venture Capital firms agreed to hear their pitch (an honor bestowed only upon the few), and then to the extent that the Venture Capitalists decided to invest (an even rarer occurrence).
•Startups were thrilled to take in funding on any terms.

22. What Is Result of VC Investment?
•Before Investment
•After Investment, more shares issued, VCs have ½ all shares
Founders own 100%
(eg 100 shares)
VCs own ½ Founders own ½
Founders (5000 Shares)
VCs (5000 Shares)

23. Alternate to VC: Angel Investors
•Angel investors are wealthy individuals (Jared Leto, Peter Thiel, Ashton Kutcher, Ron Conway) who make investments in early stage privately held companies.
•They do not have LPs, so do not need to extract VC requirements. E.g.
–No maturity date of 7 years for liquidity event
–Usually don’t take board seats
–Usually don’t demand extra info/voting rights
–Rarely take multiple times liquidity prefences
–Almost never take participating preferreds.

24. Advantages of Angel Investors
•Lower maintenance
•Lower legal costs
•More friendly terms
•No arbitrary deadlines
•Often subject matter experts
•Often have entrepreneurial experience
•Interests better aligned with company’s

25. New Method: Crowdfunding
•Now legal under 506(c) – sites like Angellist
•Ability to raise small amount of capital from large number of investors.
•Potential appeal to young companies with few contacts or socially-conscious, strategic company – marketing component.
•User of Kickstarter (alternate to equity investment) possible with med tech.

26. Before JOBS Act
•Prior to the JOBS Act (and the emergence of the angel investment community) startups had very few choices in raising capital.
–Why?
•Ban on public solicitation. They had to keep their efforts quiet because they were advised that any public mention of their fundraising could jeopardize the outcome.
•Founders that lacked wealthy friends and family were directed towards Venture Capital firms .

27. Crowdfunding Rules for Companies
•May raise up to $1M, LESS amounts raised in prior 12 months.
•Must conduct the transaction through a broker or registered “funding portal.”
•May not advertise, except to direct prospects to the broker or through a funding portal.
•Filing and disclosure obligations.

28. Crowdfunding Rules for Investors
•Individual Investment Caps
–Income or net worth less than $100,000, cap is greater of $2,000 or 5 percent of investor’s annual income or net worth.
Or
–Income or net worth equal or more than $100,000, cap is 10 percent of investor’s annual income or net worth up to a maximum of $100,000.
<<Caps measured looking back 12 mos.>>

29. Examples of Crowdfunding
•Kickstarter
•Indiegogo
•RocketHub
•Onevest

30. Specific Medtech Crowdfunding Sites
•Kickstarter-like sites
•MedFundr
•MedStartr
•HealthFundr
•B-a-MedFounder

31. Drawbacks to using VC over Angels?
•There is a difference in medical devices from other technology (see above).
•Longer runway (possibly) to profitability.
•Barriers to entering business, i.e., FDA.
•Need more $$ than $1M.

32. Benefits of Angels over VC
•Raise money directly from investors who are interested in your area.
•A successful crowdfunding campaign can validate the concept and establish market demand for the product, thereby making it more appealing to potential future investors.
•For example, a product can appear more interesting to other investors because you have the ability to prove your business model.
–You can build an actual product.
–Get some initial customers.
–Let the market weed out good and bad business ideas.

33. Food and Drug Administration
•Crowdsourcing can alert the FDA.
–They can send a “It has come to our attention letter.”
–An example is “uCheck.”
•uCheck is urinalysis. Users urinate on a test strip and place it on a color-coded mat.
–Then they take a photo with the camera’s phone.
–The app analyzes the strip colors against the swatches on the mat, and returns data about glucose, protein and ketone levels in the sample. The user can save readings and track data over time.
–Further, the company’s website states that, “Using a urine dipstick along with uCheck can help you detect presence of up to 25 diseases, diabetes, pre-clampsia, urinary tract infection, etc.”

34. uCheck’s Response
•Most importantly, registration has absolutely nothing to do with the issue that FDA has raised (which is the fact that the company needs to get FDA clearance before going to market). Getting clearance can be a substantial undertaking and it would appear that the company has not done the type of clinical research that would be necessary to support clearance.
•The fact that they've done something – one thing that the FDA requires, hardly seems relevant or for that matter impressive. I assume that they also sent their mothers’ cards on Mother's Day, but that hardly seems a defense to failing to seek FDA clearance before marketing.
•What getting FDA registration means:
–It means they spent literally at most a half-hour on the agency's website typing in basic information about their location.

35. Angels
•Benefit
–Don’t take as much equity as VC’s.
–Don’t usually take board seats.
–Generally will let you do what you want.
–No liquidity preferences.
–May have a bigger time frame (funds are not time sensitive).
•Downside
–Less money than VC’s.
–Need more of them.
–Angels may or may not be interested in your area.
–May be fewer in Medtech than other areas based in need of expertise and understanding of constraints.

36. Forms of Investment
•1. Convertible Notes
Coverts into equity upon the occurrence of an event.
•2. Preferred Shares – e.g. Series Seed
•3. Venture Debt (e.g. Silicon Valley Bank)

37. How Do You Get The Money?
•Equity
–Selling interests in your company.
–Sharing company with others.
•Debt
–Talking loans, liability versus asset.
–Secure assets, including IP.
–More like taking a mortgage on your house but the collateral is the company.
–This in some case can mean ALL of the assets, e.g. A/R, IP, Desks, Chairs, The White Board in the Conference room.
•Hybrid
–Debt that converts into assets. Not really debt financing, more like equity.

38. Conclusion
•First you need to decide WHY you need capital.
•Then you need to decide WHO to get it from.
•Finally you decide HOW you want to receive the money.

39. Curtis E. Smolar, Esq.
415-364-5575
CSmolar@foxrothschild.com