Healthcare innovation

The medical product innovation process (part 2)

Authors: Ryan Kerstein, Christian Fellowes, Alan Selby, Victor Chua, Gursharan Randhawa, Keith Heaton, Stephen Reeders 

Publication date:  30 Jul 2011


Ryan Kerstein, Christian Fellowes, and colleagues complete their two part series advising doctors on bringing an innovation to market

In our previous article (BMJ Careers 20 Jul, [Link] ) we highlighted important considerations for turning a medical innovation into a product, and we touched on some early strategic considerations. This article develops these themes but will focus mainly on commercialising a product through a spin-out.

Company types

If forming a new company is the chosen route to market, you need to consider the type of company. Figure 1 lists some of the advantages and disadvantages of the common structures of new companies.

Commercial strategy: assembling the team

Forming a good management team is extremely important but often overlooked. Success will be boosted by finding business partners who complement your skills, who have equity in the business, and whom you can trust.

Recruiting team members, such as an experienced manager, should be done with care. Surrendering equity to management can be highly beneficial, as it aligns their interest with yours. Bringing in the right person who gives sensible advice on investment and market entry can help you obtain an even better deal from future investors. For instance, self funding to achieve patents, licences, sales contracts, or profitability before looking for investment will mean that you achieve a more appealing arrangement as your company is less risky and therefore a safer investment. This means you should have to surrender less equity for a set amount of investment.

Appropriate people may be those you already know. Alternatively, technology transfer offices often have contacts with a track record in new companies. From a practical point of view, if you all bring equal benefit to the company you will probably find that an even split is easiest to negotiate and fosters a sense of equity. Uneven splits can rankle years down the road. Of course, for business partners who join a long time later, when a company is more developed, a smaller shareholding is appropriate, as they are taking less risk.

The most important thing in selecting your partners is trust. Choose business partners as carefully as you might choose a life partner—corporate divorce is difficult and messy and may destroy your company.

Why is a good team important?

Many inventors have an unshakeable belief in their idea and its worth. However, investors will be more objective and will want to assess an idea on the basis of its deliverability, potential profitability, and risk. Success in all these factors depends on a credible management team, and many ideas fail to secure investment because of lack of confidence in the team rather than in the idea’s potential.

In addition to funds, some investors can bring “value” to your business as team members. For instance, would the reggae musician Levi Roots’s Reggae Reggae Sauce have been a success had he been left to develop it himself without his appearance on the BBC2 Television’s Dragon’s Den programme, in which hopeful entrepreneurs are assessed and helped by a team of wealth investors? Investors often have industry expertise and contacts to help commercialise a product.

Commercial strategy: bringing the idea to market

A common pitfall is the belief that an idea is so good that it will sell itself. This false presumption may lead to unrealistic expectations and valuations. Unless you have discovered penicillin, the truth is that most healthcare companies succeed on the quality of their distribution channels, their marketing effort, and the quality and quantity of their sales teams—rather than the quality of the product.

Even if your product represents a major clinical improvement, expect opposition and delay from whoever is asked to pay for it. For example, clients at Candesic, a strategy consultancy firm, are told that it takes two years to launch a truly distinctive diagnostic product and 7-10 years to achieve peak sales. This is because there are many stakeholders and because healthcare professionals are notoriously conservative and loath to change their practice. Once healthcare professionals are convinced, there is still the matter of persuading the funding bodies.

Developing your strategy

An important way to show that you know how to unlock the potential of your business is by developing your business plan. This document, usually in a standard layout, is an essential element of any approach to an investor. Business plan templates are usually easy to get; we obtained a basic layout from a high street bank.

Many entrepreneurs find that writing a business plan helps them crystallise their thoughts. You will have to articulate your underlying market assumptions and financial projections, which will improve your understanding of the intended market.

The business plan will also be screened by potential investors (much like a CV). People with good business plans will be invited to “pitch” their idea in person to the funding body; bad business plans will be filed away or discarded.

It helps to read a few business plans (even in very different areas) before you start one. If you have not seen one, you should contact your local entrepreneurs’ club (many universities have one) or even high street banks. When creating a business plan you should conduct basic analysis to consider internal and external factors that can affect your plan. These can contribute to a SWOT (strengths, weaknesses, opportunities, and threats) analysis (fig 2 ). You might also include market analyses such as PESTEL and Porter’s five forces analysis, but too much reliance on well known frameworks may give your business plan the feel of a business school project.

When developing your strategy it is best to partner with an experienced businessperson in the healthcare field (which need not be in exactly the same area your idea falls in, as business skills are transferable). An experienced entrepreneur or businessperson may be willing to work for a share of the company.

However, once your company is established and has seed capital, you may find that to obtain further “rounds” of funding you will need to commission an external piece of market analysis from a recognised consulting firm to convince funders to invest larger amounts. The investors will probe you on your assumptions and make their own judgment on whether they agree, through contacting experts in the field. Therefore employing consulting experts may help in establishing a strong portfolio to present to potential investors. However, consultants are not cheap: if you are asking for £5m to expand your company, expect to spend at least 2% of that on lawyers, accountants, and consultants.

Funding a new venture

The most difficult step in launching a new venture is funding it. More ventures stall because of failure to fund them through to success than because of a lack of good ideas, technology, or markets.

The main sources of funding are professional venture capital firms, “angel investors” (usually wealthy individuals), technology transfer offices, and government backed grant programmes. As with any sale, selling your idea to an investor is about understanding what the buyer wants. Government backed programmes are usually easiest to understand, because they want strategic benefit. Unfortunately government programmes are not designed to take an idea all the way to market and are at best a bridge to angels and venture capital firms, both of which are motivated by return on investment. So, tell them why yours is a good investment.

Angels will often provide mentoring and day to day management help and will sometimes offer the best terms. Venture capitalists invest for a living and will provide the best long term support for a start-up, but they know the market and are choosy.

Venture capitalists know that the single biggest factor in building a successful business is people. That’s because new businesses never follow the best laid plans, and only the best people can navigate the inevitable unexpected obstacles. As a result, professional investors focus on the people in a business. The questions they ask of entrepreneurs may seem to be about the details of the business plan but are actually aimed at assessing whether the people involved in a business can think on their feet, have the right experience, and can deal honestly with the challenges facing even the best business plan. Surround yourself with the best people you can find and provide them with an incentive to help. Associating yourself with people who have experience will greatly improve your chances of securing funding.

Structure of investment in a start-up business

Most medical products are complex, because they are regulated by governments, prescribed by doctors, used by patients, and paid for by insurers or the state. Thus four types of stakeholder are needed to make a medical product a success. As a result such products are expensive to develop and bring to market. Development stage medical companies are usually unprofitable, and investors must be prepared to continue to invest over many years through to profitability. As a result, the risks are much higher than for almost any other form of investing. Investors will expect fund returns of at least 30% a year or 200% profit over the life of the investment to compensate for this risk. Because at least half of all companies backed by venture capital are unsuccessful, the successful ones must yield 60% annually or 400% profit when they do work out. Experienced investors stick to simple structures when funding early stage businesses. Investors ensure that capital is paid back first by investing it as debt or, more commonly, preferred shares.

How much the inventors keep in the event of success is determined by negotiation. If a venture capital firm is interested in investing, it will provide a non-binding offer, known as a “term sheet,” setting out the major parameters of the deal. The term sheet will specify the amount that the venture capitalist is prepared to invest to achieve an agreed objective, usually a value creating milestone such as completion of “first in man” studies or, perhaps, regulatory approval for a medical device. The venture capitalist’s investment in preferred shares will usually carry special privileges. Chief among these is the right to receive back, before any other proceeds are distributed, the cost of the investment plus a cumulative dividend of, say, 8% a year when the company is sold or goes public.

The term sheet will specify a number of ordinary shares that the founding team will receive. It may also specify a number of shares to be used for grants of stock options that are usually needed to recruit a talented team (the “option pool”). Finally, it will specify who has the right to a seat on the board.

For example, the venture capitalist might agree to invest £3m in RiskyBio at £1 per preferred share with an 8% annual cumulative dividend. The founding team is allocated 2 000 000 ordinary shares, and 1 000  000 shares are set aside for the option pool. The value of shares ascribed to the founders and the option pool is called the “pre-money” and is equal to the price paid per share by the venture capitalist, multiplied by the sum of the number of shares owned by the founders and the shares in the option pool. In this case, the pre-money is £1 × (2 000 000 + 1 000 000) = £3m.

The pre-money valuation of a company offered by the investors will depend on many risk factors (“downside”) and the size of the market opportunity (“upside”). For example, a higher pre-money will be achieved if the product has issued patents rather than patent applications. Venture capitalist investors see hundreds of opportunities each year and have a good idea of the going rate for pre-money. Nevertheless, different investors estimate risks differently, and entrepreneurs must shop around for the highest pre-money available. Price is not the only thing, however, and a venture capitalist with a strong reputation and a history of success will often be a better partner than the one offering the best price for its capital.

The exit, return, and reward

In an exit, such as a company sale, the invested amounts and dividends are paid back to the investors first, and then the preferred shares are converted to ordinary shares and the remaining proceeds of the sale are distributed according to the number of ordinary shares held. If RiskyBio is sold for £13m, for example, and £1m of dividends have accrued, the venture capitalists would receive their invested amount (£3m) plus the dividends (£1m) and 3/6ths of the remaining £9m, a total of £8.5m. The founders would receive £3m and the option holders £1.5m.

As a company grows, it may need serial financing rounds for new product development and launches. This is where the interests of the founders and investors may diverge. Investors are able to invest further capital to increase their shares, whereas founders and management typically don’t have the funds to maintain their shareholdings. The issue of new shares to investors “dilutes” the founders’ percentage ownership. Good investors will make sure that the founders and managers have enough economic value in their shareholdings to maintain motivation, often by allocating new share options to the founders and management. There is no way for a founder to protect against dilution except by continuing to provide value to the company or by being able and willing to invest alongside the investors. Luckily, investors rarely, if ever, dilute founders simply to penalise them; founders who continue to contribute will typically do well economically if the investors do well.

Conclusion

The main messages are that it is vital to protect your invention, vital to develop an appropriate commercialisation strategy, and, if forming a medical start-up, vital to build an appropriate team, as this is what investors also buy into. It is better to have a smaller portion of a successful product than a larger portion of something small.

Paraphrasing Thomas Edison’s famous quotation, we have found that developing a new idea truly is 1% inspiration and 99% perspiration, though it is a thoroughly enjoyable experience that provides great satisfaction if it works.

Further information

For further general information, please contact the authors:

We thank Professor Ara Darzi for his assistance and support for this article and all the coauthors of the article.

Competing interests: None declared.

Ryan Kerstein registrar, Department of Plastic Surgery, Royal Free University Hospital, London, UK
Christian Fellowes founder, ASep Healthcare, London
Alan Selby senior associate, Torreya Partners, London
Victor Chua partner, Candesic, London
Gursharan Randhawa technology licensing associate, Imperial Innovations
Keith Heaton managing director, i2r Medical, Bournemouth, Dorset, UK
Stephen Reeders founder, MVM Life Science Partners LLP, London

Correspondence to: R Kerstein  ryan.kerstein@victor-lloyd.com

Cite this as BMJ Careers ; doi: