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Wednesday, November 4, 2015

Should Venture Capital Be Concerned With Digital Health Investments?



Large Series A financings are a worrying digital health investment trend

 

(from MedCity News)

The recent large Series A financings in digital health caught my attention. Clover grabbed $100 million in equity and debt financing, Color Genomics raised $15 million, Cure Forward raised $15 million, Honor raised $20 million and Lyra Health raised a whopping $35 million.

One could argue that a data-driven insurance company like Clover will absolutely need every penny of the $100 million, but handing $35 million to a brand new company targeting behavioral health solutions, like Lyra, doesn’t make a lot of sense to me.

Although the proliferation of $1 billion + mega-funds has made it hard for many venture capitalists to justify smaller Series A investments, I don’t think this is the right approach for venture capitalists or for startups. The excess capital creates the wrong incentive structure for long-term success.

As soon as a large Series A is closed, entrepreneurs will have a strong temptation to spend this money faster than is prudent which can quickly lead to inefficient, and sometimes wasteful, spending.  This pressure to spend could come from within or from investors directly, as they expect this money to be used to generate returns on their investment.


In my experience, most companies don’t need to spend a lot of money in the early days as their core technical product is often developed by a very small, very smart, development team that iterates quickly and efficiently. Startups that try to shortcut this process end up skipping out on market research, testing with pilot customers and carefully checking product-market fit.

Another common mistake of cash-rich companies is to ramp up sales before they have figured out a repeatable, scalable sales process and viable sales channels. Although sales personnel are often strongly bonus incentivized, it’s very expensive to spin up a large sales force. Money spent too early on non-productive sales personnel is entirely wasted.

Whether it’s trying to scale a sales force, add business development talent or recruit developers, startups that try to hire too quickly often hire poorly. Instead of waiting for A-players, companies settle for whoever is available. A bad fit slows the team down and often ends in painful terminations, which waste a lot of time and money, both directly and indirectly.

Large Series A rounds are highly correlated with very high valuations which can cause other problems too. First, this increases early stock option strike prices. One of the benefits of being an early employee is getting options that have a value in pennies, not dollars. This is taken away when the Series A valuation is already high. High valuations also set higher exit expectations which take the option of an early and smaller M+A, off the table. Investors still expect outsized returns on the larger valuation.

What’s a better way to deal with this? Historically the venture capital community relied on a milestone-based investment approach where the company was funded with enough capital (plus reserves) to get to specific, value-creating milestones. These smaller rounds create expectations that the company will hit manageable milestones over time in an efficient manner — increasing value with each subsequent round and iterating along the way. This creates achievable incentives that focus the team on specific goals but also engenders a sense of urgency to create appreciable value.

Still, there are some good things about raising very large rounds. This extra cash should last longer and free up the CEOs time, which is so often spent on fundraising. This allows CEOs to focus on building their business. It’s also very helpful, once the company is selling product, to have a strong balance sheet. This is valuable in all businesses, but especially in health care.

That said, history tells us that massive Series A rounds can have disastrous results. The tech industry has many examples of over-funding hot companies like Quirky (crowd sourced inventions) and Clinkle (next generation payments), which delivered major losses for investors.  Color Labs was perhaps the most infamous. The company raised a $41 million seed round in 2011 by some of Silicon Valley’s top venture investors. Color quickly became a media darling as they hired rapidly but flamed out just as quickly as they shut down and sold their assets to Apple in 2012 for $7 million.

Let’s not make the same mistakes this time around in digital health. It’s best for all if emerging companies that raise large Series A rounds like Color Genomics don’t suffer the same ignominious ending as their tech company peers like Color Labs.
 

 


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