deal structure for healthcare entrepreneur

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Deal Structure for theHealthcare Entrepreneur:

A Guide to Achieve MaximumReturn, Minimal Risk and Maintain

Control of the Decision Making Process

By Luis Pareras

Published by Greenbranch Publishing, LLCCopyright 2012 by Greenbranch Publishing, LLC. All rights reserved.

Sponsored by:

S P E C I A L R E P O R T


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Copyright 2012 by Greenbranch Publishing, LLC. All rights reserved.

Published by Greenbranch Publishing, LLCPO Box 208

Phoenix, MD 21131Phone: (800) 933-3711

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All rights reserved. No part of this publication may be reproduced or transmitted in any form, byany means, without prior written permission of Greenbranch Publishing, LLC. Routine photocopy-ing or electronic distribution to others is a copyright violation.

About the Author

Luis Pareras, MD, PhD, MBA, is a neurosurgeon and Director of Innovation and Entrepreneurshipat the Barcelona Medical Association. He serves on the boards of several healthcare start-upcompanies and he holds a Global Executive MBA from the IESE Business School.

Pareras is a physician-entrepreneur, being involved in the launch of Medicine Television, wherehe served as General Manager for 5 years. He advised venture capital firms in their healthcareinvestments, providing deal flow and healthcare sector analysis, and he serves on the investingcommittee of Alta Partners Venture Capital Fund, as a specialist in healthcare investments. Dr. Par-eras is also Director of Healthequity, a venture capital firm investing in the life sciences, medicaldevices and healthcare services.

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VALUATION DOES NOT STAND ALONE. Many healthcare entrepreneurs understand

very well the economic aspects of the negotiation. But there are other aspectsequal to or even more important that should not be overlooked. When investors

analyze a venture capital investment, fundamentally they are looking for:

Getting the maximum return on their investment.

Reducing to the minimum their risk in the investment.

Controlling the possible conflicts of interest that inevitably can emerge during the re-

lationship with the entrepreneurs.

Therefore, regardless of the companys valuation, investors and entrepreneurs should

tackle a series of questions in order to allow the investors to:

Align the interests of both parties and push all of them in the same direction (incen-

tives, stock options, and so on). Protect their investment.

Control the decisions that are being made in the company (where the money is in-

vested).

Therefore, the possibility that the negotiation ends successfully depends on the capac-

ity of both parties to reach a good relationship framework, and regulate their future

coexistence by a series of agreements that minimize the conflicts of interest. These

mechanisms and financial instruments that the investors and entrepreneurs use to design

and structure their investment agreements are known as deal structure which once

negotiated and approved, allow for the shaping of the relationship that is being initiated(Figure 1).

Logically, each side has its own point of view and objectives to defend, and it is not

an easy negotiation. From the investors point of view, the best agreement is one that:

Provides common incentives to both parties for, on one hand, the company to grow

and to have the maximum possible profits and, on the other hand, to protect their in-

terests.

Allows an exit from the company (disinvestment) at the most opportune moment so

that the investors can reap their efforts.

From the entrepreneurs point of view, there is the wish to retain the highest percent-

age of ownership of the company as possible for themselves. This makes sense becausethe entrepreneurs are betting a lot on their project and should feel that the company be-

longs to them in good proportion. Contrary to the fear many entrepreneurs have, this dis-

cussion usually ends up being fair for both the venture capitalists and the entrepreneurs,

Deal Structure for the

Healthcare Entrepreneur:A Guide to Achieve Maximum Return,

Minimal Risk and Maintain Control of the

Decision Making Process

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Deal Structure for the Healthcare Entrepreneur:A Guide to Achieve Maximum Return, Minimal Risk and Maintain Control of the Decision Making Process

FIGURE 1.

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given that if the entrepreneurs lose too much ownership in the company and end upwith a very small percentage of participation, they can lose the motivation and enthusi-asm in the project, and this does not benefit anybody. Investors know that the entrepre-neurs leadership is fundamental for the future success of the company and as we will

see, they try not to stretch beyond what is reasonable at this point.In this report we will see 21 issues that should be negotiated with the venture capi-talists before arriving at a definitive agreement.1 The reader will notice that we will usea specialized jargon that is used continually in the sector. Perhaps the terminology isunknown to healthcare professionals but we will make an effort to explain it in the mostcomprehensive way, because it is worth the pain for the entrepreneurs to have a generalunderstanding of the terms that are used during negotiations.

PROVISIONS TO ALIGN BOTH PARTIES INTERESTS

One of the most important topics for negotiating the venture capital investment in the fu-ture company is the definition of incentives for the entrepreneurs, in a form that makesthe company grow according to the plan. These are the agreed expectations they assumeas a reward for their labor. This is very important for both parties, given that in this waythe entrepreneurs begin to see their idea moving forward and the investors are as-sured that the entrepreneurs are moving in the right direction at that moment.

Among the questions that are included in these clauses of aligning interests we canfind: The basic remuneration of the companys key people, including stock grants and op-

tions for the entrepreneurs at predetermined times in the companys evolution. In what circumstances the Board of Directors can fire the entrepreneurs (and the

economic compensation that will be paid to the entrepreneurs in this case). Non-compete clauses if they leave the company, meaning the time during which they

cannot deal with clients, providers, or related people within the sector after leaving. Benefits the entrepreneurs may receive in the case of meeting or surpassing their objec-

tives.

(1) Stock Grants and Stock Options

Entrepreneurs have a lot of information about their project and the healthcare sector.Normally investors are at a disadvantage when it comes to accessing to this informa-tion. Lets not forget that for the investors each company is one of a portfolio of compa-nies that they is investing in, while that for the entrepreneurs, their company is probablythe project of their life. Investors always try to align the entrepreneurs interests withtheir own to ensure the maximum cooperation. If the entrepreneurs have a reward forgoing in a direction that assures a good economic return for the investors, it is clear thatthe collaboration between both parties grows significantly.

One of the most common formulas to align both interests consists of the transfer ofshares that directly increase the ownership percentage for the entrepreneur, known as stockoptions. These options grant the possibility of buying future shares in the company at a pre-determined price that is usually lower than the price the company could charge if every-thing goes well.

These mechanisms usually are associated with reaching important goals and mile-stones (aligned with the venture capitalists interests), such as: Earning profits above an agreed upon amount.

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Creating the conditions for a satisfactory exit from the company on behalf of the ven-ture capitalists (disinvestment).

Capturing clients or important partners for the future of the company, among manyothers.

(2) Transfer of Shares Plan to the Entrepreneurs (Vesting Rights)

Besides the binding agreement of predetermined share transfers to the entrepreneur de-pending on the companys results, entrepreneurs and investors usually agree to auto-matic transfers over a specific period of time, in order to keep the entrepreneurs frombeing tempted to abandon their position in the company and to start another new idea.If the entrepreneurs are guaranteed an increase in participation in the company over thefollowing year, for example, it will be much harder for them to leave the project.

(3) Conditions for Firing Entrepreneurs

This is a very delicate topic in the discussion between entrepreneurs and investors, asthe entrepreneurs logically consider this subject as an attack on their potential to leadtheir project in the future. Nevertheless, it is a topic that needs to be dealt with andmade clear before arriving at a definitive agreement. A recently created company, asit grows and moves forward in the attainment of its objectives can, over a period oftime, come to need entrepreneurial capabilities and/or different managers from thoseat the time of creation. It is possible that at some time in the start-ups evolution, amore experienced CEO or general manager could allow the company to grow faster.This is not necessarily bad news for the entrepreneurs; on the contrary, it will likelymean that their company has had great success and that they need to professionalize

the management. And it does not mean that the entrepreneurs are losing their posi-tion of influence; it simply asks them to show more confidence in other experts inorder to continue creating value for all (investors and entrepreneurs). Lets rememberthat ownership of the company and its management (rights of control) are differentthings: the entrepreneurs can continue being the owners of a good portion of the com-pany while allowing others to manage it. In many instances, this loss of position canbe negotiated by adding compensation with more company shares or any other waythat seems reasonable. When the firing is the result of a series of more dramatic rea-sons, such as for example the noncompliance with the Board of Directors instructionsor the inappropriate conduct in the withdrawal of funds from the company, things

are different, and should be analyzed on a case by case basis.

(4) Conditions for the Voluntary Exit of Entrepreneurs

In spite of all the efforts to align both parties interests, at times entrepreneurs aretempted by a different project and they decide to leave the company. On other occasions,this exit is the cause of a retirement, an accident, or the death of someone important inthe company. Therefore, many agreements include buyback provisions so that the com-pany can buy back all or part of the shares from the entrepreneurs at a predeterminedprice in the event that they leave the project. This predetermined price usually dependson:

The circumstances of the exit. The time that they have spent with the company. The market value of the company, among many other things.

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For example, frequently the entrepreneurs that are leaving make an agreement onthe sale of shares at nominal cost price. If on the other hand, it is a sickness or retire-ment, it can have been agreed that the entrepreneurs receive the total value of all theirshares or that they can retain a part of them.

(5) Non-compete Provisions

This is another of the clauses that in practice is difficult on a major level in the relation-ship between healthcare entrepreneurs and venture capitalists. This provision is negoti-ated to stop the people that are leaving the company from using the information,contacts, and the sector knowledge to compete with the company that they are leavingfrom their position in a new company. It also includes clauses that stop them from per-sonally creating a start-up or making transactions with well-known clients or providers.Logically, the non-compete provision has a time limit from the time it goes into effect, forexample two or three years. This tries to avoid the feeling that entrepreneurs are losing

everything and all their freedom to try to create a new start-up in the future. They justlose that freedom for a specific time frame.

(6) Salaries: Founder and Managements Compensations

This topic was already dealt with during the analysis of the business plan (these num-bers are already in the financial projections). After the valuation of the company, in-vestors will deal with this topic in a more open way with entrepreneurs. The salariesproposed by the start-up management team are rarely discussed, but without a doubt,should be reasonable: For the salary levels in the sector.

For the level of responsibility of each one of the founders and managers. For the perception of value that they contribute to the company as a whole.

Salaries should not be too high, spurring the concern by the investors that there willnever be a sufficient stimulus to make the company grow (having an already satisfactoryeconomic situation), nor too low, offering a image of low self assessment on the part ofthe start-up team. Salaries should be perceived by all as fair and balanced in the circum-stances.

(7) Bonuses According to Objectives

The start-up world is a competitive one. Some of the key founders/managers will be in-

vesting their time and efforts in something that is not a certain success. Therefore,bonuses are commonly established depending on the results that make the collabora-tion most attractive for all.

A great risk is, logically, something that should have a greater profit. Lets not forgetthat if the entrepreneur wins, the investor wins, in the symbiotic relationship alwayspresent between both.

PROVISIONS TO PROTECT THE INVESTMENT

Between the entrepreneurial team and the investors that finance the idea, there is usu-

ally a great difference in knowledge about the new company, including the sector wherethe new company is operating. This is especially certain in the projects of the health sec-tor, given that there is a strong research and development component, and the investors

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lack the technical knowledge needed to evaluate the managers decisions in the newcompany. Given that the investors contribute a good part of the necessary money for therunning of it, it is logical and understandable that they develop a series of provisionsand mechanisms to protect their investment. These issues also will have to be dealt with

in the venture capital negotiations and they include: Phased investment, contribution of capital by milestones. Preferred stock versus common stock shares. Convertible debt versus normal debt. Common stock purchase rights tied to (poor) performance (call option). Obligatory share redemption (put option). Automatic conversion in certain situations. Antidilution provisions. Restrictions on the transfer of control. Issuing of new shares. Preferences of liquidation. Shares sale rights. Circuits and access rights to the companys information.

(8) Phased Contribution of Capital in Milestones

This provision represents one of the most distinctive characteristics of the investment ofventure capital. When a new company tries to get financing it usually does not need allthe money at once. In place of contributing all their money at one time, investors preferto contribute capital in stages, monitoring the company and deciding if they want to con-tinue injecting the promised capital or not, minimizing therefore in a sensible way theirrisk. The investor can decide not to continue funding if: The entrepreneurial team does not comply with the expectations. The team is detouring greatly from the initial plan. The market is no longer attractive for the investor.

The entrepreneurs that in this phase are enthusiastic with beginning the project com-monly accept this type of investment and concentrate on growth, because if they do sothe possibilities of success are greater for both parties.

For example, lets suppose that healthcare entrepreneurs have designed and patenteda new medical device that improves the reading of an infants temperature. To raise cap-ital, they apply for a sufficient amount (lets suppose $1,000,000) to manufacture the pro-

totype, do the clinical study, arrive at distribution agreements, manufacture 1,000 units,and start selling them to different hospitals. The venture capitalists evaluate the project,believe in it and ultimately complete a due diligence, agree with them on the terms of theagreement, and decide to invest.

The investment in milestones in this case would mean that the venture capitalistswould not invest the total amount of the money, but rather only the first necessary partin order to manufacture the prototype ($300,000), promising to contribute the rest whenthe prototype is completed. With each new milestone accomplished, the entrepreneursreceive a new infusion of money. It is a very reasonable agreement for both parties inter-ests. With it:

The entrepreneurs know that if things go well, venture capitalists will invest a total of$1,000,000 in the new company. The investors reduce their risk because if the prototype is not completed, they do not

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lose the total amount, but only $300,000.

The previous example is a good model of financing in milestones intra-round. Onemillion dollars is solicited and capital is contributed in milestones. Another variant of theinvestment in stages is the inter-round, that is more complex, but for now will remain

outside the scope of this report. Lets suppose that the same entrepreneurs have success-fully completed their first year of company activity, have already sold the 1,000 units andare planning an ambitious expansion to sell those devices throughout the world. The sec-ond year they want to dedicate their efforts to expanding sales through Europe, and thethird year to the whole world. It is likely then that they need to ask for more money to fi-nance the accelerated growth of the sales. In this case, the entrepreneurs can decide thento go for a second round of financing (asking for $3,000,000), and after, a third round of fi-nancing (asking for $6,000,000).

These different rounds are considered different investments, and different venturecapital companies participate.

The investment in milestones therefore allows: The venture capitalists have the option of leaving or of reevaluating the project, bas-

ing the decision on the new information that they have about its evolution. Better management of the possible conflicts between entrepreneurs and investors,

aligning both parties objectives.

(9) Preferred Stock Versus Common Stock

When investors and entrepreneurs agree on the valuation of the company, the investorstry, as we have seen, to: Increase their profits to the maximum when things are going well.

Reduce to a minimum their losses if things go badly.Entrepreneurs on the other hand try to get the risk/profit to be shared equally by

both parties. In order to regulate these different objectives, the sector uses two typesof shares, the preferred stock and common stock.

Investors prefer to receive preferred stock because it represents a participation in thecapital in a priority form, with advantages (and some drawbacks as we will see later on)over common stock. This preferred stock involves therefore, less risk that commonshares, because they can: Be returned back to the investors before the common stock in the case the company

fails and is liquidated.

Be converted into common stock if the company does well, in a way that the share-holder can profit from the good results of the company.

Entrepreneurs almost always receive common stock (unless their power of negotia-tions is very high). These shares are the last ones to be returned in the case of liquidationof the company, therefore they are shares with a higher risk. This is a good incentive be-cause the entrepreneurs know that if the company does poorly, they will be the last to re-ceive something from its liquidation. Lets remember for a moment the order of priorityin the cashing out of money when liquidating a company: Debt. Convertible debt.

Convertible preferred stock. Common stock.

This means that if a company fails, the sale of the assets from that company will be

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designated in the first place to pay the debt (banks, creditors, and so on); in the secondplace, the convertible debt will be paid (we will look at this later); next, the preferredstock; and lastly, the common stock.

Common stock does have some advantages. These shares have the best potential of

earning profits, and therefore the investors are going to convert their preferred stock tocommon stock as risk decreases and the company becomes more solid. The commonstock also provides a greater degree of rights over the control of the company.

(10) Convertible Debt Versus Debt

Occasionally investors prefer that the money that they have injected into a company isconsidered debt, because we have already seen that the debt has greater priority of beingrecouped if things go bad. In the case of liquidation, the debt holders are returned themoney before the holders of shares, be it preferred or common. Therefore, occasionallyventure capitalists use convertible debt, which is nothing more than a loan to the com-

pany (in place of an investment). This loan that can be converted into shares depend-ing on a series of conditions. This gives the investors the option of being able to chooseat all times between debt or capital, again being able to reduce risk of their investment.A good example of convertible debt is the participative loans that are convertible intoshares under some predetermined conditions. We will not analyze this participative loanconcept in detail here but it is important to know that it is especially beneficial in entre-preneurial initiatives because in business, they are not de-capitalizing the start-up, al-though in the balance they are considered as a long-term loan.

(11) Put-Call Options for the Investor Bound to Objectives

Occasionally, the investor can demand that the entrepreneurs cede part or all of theirshares of the company if a series of objectives are not being met. In order to make thishappen, options are used on the shares that can be executed by the investors (similarto those that we saw before, but in favor of the investors instead of the entrepreneurs).In this way, the venture capitalist can acquire additional common stock if the companydoes not comply with the financial objectives or with the agreed plan.

This is usually negotiated in parallel to the options of share buying on the part of theentrepreneur and the bonuses, in a way that it is bound to the success or the failure, tothe increase or the decrease of participation in the company on the part of the entrepre-neur. Entrepreneurs, in the same way, get bonuses in the form of common stock if thecompany surpasses the predicted revenue projections. This mechanism is used by theventure capitalists in order to give themselves control over a bad manager.

(12) Redemption Rights for Shares

Using this clause, investors can ask for the reimbursement of their investment at anytime. So, the venture capitalists can at any time force the sale of their shares at the sameprice they paid, reselling their shares to the company.

(13) Antidilution Provisions

Start-ups usually need more than one round of financing before being able to survive

on their own. When one of these companies is going for a second round of financing: Either the current partners increase their participation contributing capital in a propor-tionate way to the new investment.

Or the participation of the existing partners (entrepreneurs and investors) will be di-

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luted with the entrance of new capital growth.

Venture capital deals usually include antidilution provisions whose objective is, as its

name indicates, to avoid the dilution when a new partner enters the company. These

provisions are instrumental in the form of options that allow conversion of preferred

stock into common stock at a price that compensates the entry of new capital.

(14) Automatic Conversion

This is another mechanism used by investors to avoid dilution. In specific circumstances,

the entrepreneurs can split the shares, issuing special dividends, dividing the value of

their shares, or selling them at a lower price than that initially paid by the investor. In

order to avoid this, some conditions (bound to some pre-agreed events) cause some pre-

ferred stock to be converted automatically into common stock.

(15) Restrictions on Transference of Control

Venture capitalists do not invest in ideas but in their execution. Therefore, they investin human teams, in people that are going to carry out that idea. Logically they want

to protect themselves from any change in leadership in the company. A sale of shares

is one of the circumstances that could completely change the control of the company,

and therefore in the agreement, the investors pay special attention to the associated

restrictions of the possible transferences of control. Investors usually demand that the

founders not be able to sell their common shares without investors expressed consent,

or, as a more reasonable alternative, that the entrepreneurs will be forced to offer a first

right to buy (call option) to the investors in the case where entrepreneurs want to

leave the company.

(16) Issuing of New Shares

If the results of the company are good, investors love to have the option of increasing

their capital contribution in order to have greater participation in the company.

If the start-up has surpassed its expectations and shows excellent progress, it is possible

that the entrepreneurs as well as the investors will decide to take advantage of the oppor-

tunity to invest additional money. Therefore, to negotiate the agreement, the venture capi-

talists try to include a clause that allows them to reinvest if they want to. On the other hand,the entrepreneurs can ask that this new investment (motivated, lets not forget, by the suc-

cess of the company), be done at a higher valuation, reflecting the excellent evolution of the

company.

One of the most common forms of guaranteeing that right consists of agreeing on the ex-

istence of preemptive and first refusal rights on all new issues of shares. So, the venture cap-

italists are assured of being able to participate, if they want to, in the new round of financing,

acquiring an option to invest in the future. This sometimes means as well that the entrepre-

neurs will not be able to get additional financing without the approval of the existing in-

vestor.

(17) Liquidation Preferences

This part of the agreement sets the order of preference in which the shareholder is re-paid if things go badly and the company is liquidated.

We cannot forget that venture capitalists invest with a very clear objective: to disin-

vest in the future. They do not have any vocation of permanence.


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This makes them very predictable, because: If the company is going very well, they will want to inject more money in order to in-

crease their investment to the maximum If the company is going well, they will look for a buyer for their shares, usually in the

same sector where the new company operates. If the company is going poorly, they will want to liquidate it (selling their shares, al-though usually at a lower price than their real value).

Therefore, investors try to put into writing that they have preference to profit from theremains of the company in case of liquidation, until recouping 100 percent of the valueof their shares, and from that moment on the entrepreneurs will also begin to profit fromtheir own shares.

(18) Tag Along Rights Drag Along Rights

The venture capitalists need to obtain an agreement that allows them to leave under the

best conditions and above all, at the time they deem appropriate.There are two instruments that allow them to do this:

The tag along rights that force the entrepreneurs to be able to sell their shares to athird party only when the buyers extend their offer also to the shareholders/investorsunder the same terms and conditions. The venture capitalists need to cover their backsin case the entrepreneurs want to leave the company first.

The drag along rights, that try to obligate the entrepreneurs to sell their own sharesin case there is a buyer that wants to buy them all at a satisfactory price. This condi-tion is not usually well-received by entrepreneurs, but needs to be discussed at sometime during the negotiation.

(19) Circuits and Rights for Accessing Company Information

We have already seen that the due diligence process tries to reduce the imbalance of theinformation that exists between the healthcare entrepreneurs and the venture capital-ists. We cannot forget that the difference of information will continue to exist during thecompanys whole life. Therefore, the negotiations usually include a series of provisionsthat sets the rights of access to the companys information that the investors have. In-vestors need to be guaranteed access to truthful information.

This is important for them because it allow them to control the evolution of the com-pany and to react in time to any change of results. The information is important in order

to plan reinvestment if it is necessary, and, also, to better plan the conditions of their exitfrom the company when the moment arrives.

PROVISIONS FOR CONTROLLINGTHE DECISION-MAKING PROCESS

As we have analyzed, the venture capitalists prefer to take preferred stock because itgives them better control of the risk. But we have also seen that this type of stock meansless theoretical control over the company. Therefore, venture capitalists need to enable ef-fective forms of control over the decisions that are being made in the company, inde-

pendently from their having or not having a majority position in it, in order to stop theentrepreneurs from making decisions against investors interests. To guarantee a bettercontrol of the company they will include:

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The presence of one or more members of the venture capital company on the Boardof Directors.

Veto rights.

(20) Presence of Investors on the Board of Directors

The representation on the Board of Directors is a key aspect for the venture capitalists.Depending on the amount of the investment, the investors can have more than just oneseat on the Board.

This is great for the entrepreneurs. It will be an important help because parties areequally interested in the success of the project and investors contribute much more thancapital. They contribute contacts, their network of influence, and their experience in thefield of the business, all of it extremely important for any start-up project.

The entrepreneurs also have, of course, their seats on the Board of Directors and theycontribute their experience also. In the case of the health sector, it is the scientific and

technical knowledge that has motivated the birth of the new company. When the Boardis controlled (with more than 50 percent) by the entrepreneurs, investors usually requirethe inclusion of norms that demand better qualifications in order to make important de-cisions. This means that key issues will require more than 50 percent approval by theBoard.

The functions of the Board are: To collaborate in the strategy definition of the company. To provide clients and suppliers. To provide a network of contacts. To attract the entrance of new capital if needed. To select and pay the key people. To be watchful of the business ethics and the good practices of the company.

(21) Veto Rights

If the investors have minority participation, they will try to guarantee the control overbig decisions and operations in the company, normally by means of veto rights over: Sale of shares. Entrance of new capital into the company. Solicitation of loans to financial entities that indebt the company. Extra expenditures. Contracts and conditions of the key company positions. Generally, any modification that suggests a change of strategy in the company.

CONCLUSIONS

These 21 issues are necessary to pay attention to during the venture capital negotiation.One cannot forget, in any case, that the interest of both parties is the same: to make thecompany succeed. It is common that these tricky topics be tackled as part of negotiatingan agreement and establishing a healthy and honest reference framework for the relation-ship. If the company does well, a confident relationship is established between both par-

ties generating trust that will allow teamwork. The venture capitalist and the entrepreneurare very motivated to move this forward and to collaborate, and a good combination ofincentives and obligations on each part will contribute to its success without a doubt.

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Bibliography

(1) ROURE, Juan; SEGURADO, Juan Luis. Negociando una operacion de capital riesgo(II): estructuacin del acuerdo e intrumentos contractuales, IESE publishing, 2-606-023, EN-11, 2005.

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