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2 min reading time
Medical device founders may clutch tightly to the idea of retaining as much NewCo stock as possible. They viscerally reject the idea of either losing their controlling authority or diluting their equity interest, or both. Early round investors, especially friends, family and angels often agree. Though the advantages of this strategy are obvious, insiders need to consider carefully the possible downsides. In my experience, one unintended consequence is an undercapitalized startup, starved for cash and struggling to achieve milestones with inadequate resources. I own stock in one enterprise that has projected accomplishing its next important big step in six months for the last seven years. With the passage of time, the danger of another new market entrant eating their lunch grows. They could well save on their fare but miss the boat. Other founders have told me that they loathe raising money, hustling to convince angel investors and or VCs to get attention to make a pitch, and facing serial rejections – even from people who stared at their mobile devices during the presentation. Worse yet, some potential investors do not respond definitively one way or the other. They seemed to endlessly discuss the idea with their partners, or ask for more information, or wait for another investor to move first. No wonder that so many entrepreneurs find the process highly frustrating, even when they are confident that they will eventually succeed at raising the next round. The balance of risks is a difficult question. Whether it is more dangerous to raise money and risk control and share of the pie, or to shun new money and perhaps slow growth or even invite getting blind-sided by new competitors. Equity-stingy founders may fail to ask the question openly, or exert a genuine effort to answer it honestly, or to revisit the question at appropriate intervals. That kind of mistake could prove fatal. source: https://www.linkedin.com/groups/78665/78665-6350356913301004290 Marked as spam
 Posted by Asked on December 23, 2017 12:00 am
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Julie Omohundro
From one of my favorite scenes in Extraordinary Measures, the movie about the development of a treatment for Pompe disease:
The MBA: Under the circumstances, this is the best deal we are going to get. The Scientist: Deal?!? These are the terms of our surrender! [They argue about the deal and the need for investors.] The MBA: Great, you can be the guy who dreamed up the big ideas that never get funded. Drawing brilliant diagrams that can cure diseases in theory, but never helped a single human being in reality. The scientist signed off on the deal. Marked as spam
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Dave Gaisser
Your last paragraph sums things up perfectly, David. My experience with start-ups supports your points on undercapitalization. Equity-stingy founders often look at their company less realistically and end up behind the curve and out of business, not achieving what they might with added investment and oversight. Delays can be market killers. A smaller share of a large pie is substantially better than the whole pie if you never get it out of the oven. (Sorry – too much pie over the holidays.)
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Rian Wendling
Working in medical devices makes this issue of holding onto equity for too long even more tempting. You have several major valuation inflection points (i.e. regulatory clearance/approval, GPOs, etc) that arent present or nearly as apparent in other industries that can lead to undercapitalizing the business in order to reach that next inflection point and warrant a higher valuation. Its a delicate battle between intelligent, timely financing and avoiding slowing progress.
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David Kaplan
A nice subtle addition to the conversation, Rian. It points out that a long term financing strategy makes even more sense in the device arena than in many other verticals. I see these inflection points as opportunities to increase valuation as risk declines, enabling Newco to steadily reduce the cost of capital. Thanks, David.
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Dear David,
As a veteran entrepreneur, I regret to admit you wrote the sad truth. The reason it is sad is that in many occasions the founders who are looking to make their dream come true, must take other's people big money that they usually do not know, risking they will lose the authority to control and be diluted to death. If the investors are not smart enough to keep the founders and the key persons happy in the company they will be frustrated and leave. Many startups fail because of such problems and smart investors should ask a good portion of the shares, but also keep this very fragile balance with founders safe to bring the company to the right height. Marked as spam
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Jeffrey Jensen
Bret J. Fox publishes frequently on startup issues (see link below). Stingy founders that don't share enough equity with their team is a common cause of failure.
Better to have a smaller piece of a huge, fabulously successful ongoing enterprise, than 100% of something that never gets off the ground. Spreading the wealth helps create a powerful company culture. https://www.forbes.com/sites/quora/2017/03/11/the-five-worst-mistakes-a-tech-startup-can-make/#6731fea162a2 Marked as spam
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After raising $42.5M as Founding CEO for a medical diagnostics business, and holding onto Founder equity (no VCs), I am enjoying this discussion. We did miss some milestones, but it was not necessarily due to under-capitalization. It was due to inexperience and losing focus on the main game (some unnecessary spending in areas which, in hindsight, may not have been necessary). I really agree that it is a delicate balance of risks. sound decision-making is critical. The quality and independence of the Board of Directors is also important in guiding Founders in making the right decisions at the right time. Our company survives, and now has FDA clearance, but it is still pre-revenue!
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David Kaplan
Every startup is, unique, of course, and no generality could ever apply to all of them. Sounds as though you have faced a somewhat different set of challenges and learned important lessons from them. Medical device enterprises mostly face long paths to their first earned dollar. An involved and insightful board can be a crucial resource in finishing the marathon.
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Muhammed Hamdan
That is a very important topic, David! Thank you everyone for sharing your valuable insights and experience!
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Jonathan Wacks
Great topic! As my daddy once said, a percentage of something is better than 100% of nothing.
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Roger Cepeda, JD, MBA, RAC
I supported startups for years as outside counsel and the more upside/equity was shared, the harder everyone worked together, including "smart money" investors, employees, and advisors with equity interests. And as the authors here no doubt already understand, there are several types of equity besides direct voting stock ownership that can be tailored to balance control, risk, and reward (e.g., warrants, options, convertible debt, restricted stock, etc). As long as the cap table and valuation showed increasing overall value, everyone remained happy even when the founders fell below the level of a controlling interest. Dr. Hendriks' approach (no VC funding) is probably the best, but few companies can do it without some type of angel investor willing to accept a long-term exit horizon.
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Peter Travers
I appreciate the nuances of this conversation. In our case it’s not so much a willingness to take less of the pie, but a desire to not spoil the pie. There is an old saying “companies don’t become what they plan to be, they become who they hire”. In this case companies become who they allow to invest in the mission. Our company measures success by two currencies. 1 how many patients we can help survive cancer and 2 how much ROI we can get our investors. Seeking to maximize profits for one group of investors can create long pipelines, literally allowing people to die awaiting approval. Breaking up the pipeline speeds up the process, but spreads the profits around to others. It’s a reversal, the investors don’t want to share the pie, so people die. I think long pipelines in todays world of change are not worth the risk of becoming obsolete. The base therapy our device operates on has been shown effective on 20 types of cancer. Running 20 trials through the approval process would take lon
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I think this is part of a larger discussion about "Founders Syndrome." It is especially prevalent among inventors. It's a matter of a gift - the ability, focus, and dedication to create something, becoming a liability due to distrust, arrogance, naivety, or fear of loss of control. This can lead to poor decisions when investors come knocking. I looked on in horror as my brother-in-law lost his renewable energy invention to investors. He did not have a Plan B when he lost a state grant. His investors swooped in and took over. But he had refused to develop any other relationships with investors whom he might have called upon. Create a short list of investors, vet them and keep them in the loop.
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David Kaplan
Broadening Sharif's focus from "inventors" to "founder's" more generally rings true, Melanie. Good point! One encounters this sort of reluctance across a spectrum that includes inventors, founding partners, friends and family and other early stage team members and investors. Perhaps inventors are more prone - I have no data - but inventors may be a more a proxy here for a lack of clear business insight. Unfortunately, that condition may affect all manner of constituencies of a startup. Achieving the right cash on hand vs. dilution balance in a particular situation requires an often subtle mix of information, judgement and seasoning. Startups don't always have the resources to make these tough calls at the point when they arise. Many just don't know what they don't know. I agree with your strategy of lining up a short list investors - perhaps some with early-stage BoD experience.
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Glyn Braithwaite
In much of the responses and even the main article there's either a miss on delivery or request for additional cash - this seems to require additional value and / or growth to satisfy the investors. The question that I'm sure most would ask is "why was initial valuation/timeline incorrect?" That would be an interesting list of responses that all VCs will always carry with them.......
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David Kaplan
Marjorie - General advice is difficult, because each startup has different needs and resources, operates in its own market realities, and other idiosyncratic factors. Still, it is altogether too common that ventures struggle to get to market because the founders held too tightly to their own stake. The only broadly applicable advice may be to analyze these kinds of decisions carefully. Be vigilant for this species of potential conflict between the retained shares of the founders and the adequacy of budgets to move the company along. Experienced advisers might add insightful perspective.
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David Kaplan
Not sure that I follow your argument entirely, but founders hoarding equity may have no relationship at all to an error with the "valuation/timeline." Some founders never raise equity funding at all and attempt instead to bootstrap in an in an inappropriate situation, for one example. Other founders may attempt to continue product development by over relying on grants. Valuation may not be an issue at all. Of course, under-capitalization will virtually always slow the timeline.
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I started a business as an intrepreneur inside a great medical device company. While we had the advantages of a fabulous corporate "bank", I was not able to get the team the equity they really deserved. This proved to be the biggest thorn in our side for what was otherwise an incredible start-up environment. For those with the financial flexibility, getting the founders and start-up team a fair amount of equity should lead to stability and with other factors in place (see : Commanding Excellence, https://www.igarymorton.com) phenomenal long term results.
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David Kaplan
Founders equity issues appear in many different forms. This is virtually the opposite situation to the one the original article confronted. Intrapreneurship certainly alters many aspects of startup landscape. Founder's equity is a powerful motivator. It can be difficult for corporate managers to escape the employer mindset to recognize the value of ownership in fueling innovation.
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