15 Steps to a Start-up Investors Will Buy
From day one, Tom Weldon worked to position his competitive but risky start-up to appeal to investors. So far, so good
While many entrepreneurs believe that a well-planned strategy, talented management, or an exquisite product will ensure their company's success, Tom Weldon is not among them. To him, the drive for capital must be the primal urge that informs and energizes a young company. "Money is the lifeblood of any company," says Weldon. "Whatever you do early on in the life of your company should be oriented toward raising money for product development."
Weldon is the president and principal founder of Novoste Corp., a start-up about to enter the hotly competitive -- and now highly uncertain -- medical-devices industry with products focused in the specialties of electrophysiology and interventional cardiology. To the unschooled eye, Novoste seems indistinguishable from your garden-variety technology start-up. The company has leased space in a nondescript suburban industrial park outside Atlanta, and at this point it has few bodies, much energy, and many ideas still waiting to come together in the form of salable products and real revenues.
But what has broken Novoste somewhat out of the pack is that last October the company landed $2 million in venture capital from a top-drawer venture firm, the Hillman Co., based in Pittsburgh. (See "The Silent Partner," page 4.) While the signing of that deal gave Novoste legitimacy and life, it also signaled an end point of sorts to the company's quest for capital, which had begun in earnest 16 months earlier.
In retrospect Novoste's search can be seen as a 15-point plan applicable to service-company start-ups as well as to manufacturers, to those seeking money from venture capitalists, private investors, or even traditional lenders. While every start-up's financing is different, the steps leading up to the Hillman-Novoste deal -- and the reasoning behind each step -- can inform any aspiring and capital-hungry entrepreneur. What follows, then, is Weldon's plan, step-by-step:* * *
1. Determine whether equity or debt will be the funding source.
Although many entrepreneurs fund their companies with their own or the bank's money, for Weldon equity funding was really the only way to go. "It would not be possible to fund our company with debt. We have no products and no cash flow right now," he says. If a company is eventually successful, equity is a very expensive way to raise capital, since stock sold for $1 could someday be worth $10 or $20. On the other hand, notes Weldon, "that premium is the compensation we pay to the investors for the risks they take."
Weldon concluded that if he structured his company carefully and executed his business plan, equity in Novoste could be good hard currency. That view differs from that of many entrepreneurs who want to hold major equity stakes in their companies, fearing dilution or lack of control. Weldon, by contrast, has paid most of his advisers and contractors in stock. He has granted liberal stock options to his employees -- and pays them modest salaries -- thus aligning the interests of employees and investors in the search to build value for the long haul, and to slow the cash "burn." "This is a team approach," he says, "and if the company is successful, there's no need to be greedy. We'll all get rich."* * *
2. Develop a business strategy.
Weldon wanted to avoid the trap of applying the strategy he had executed -- successfully -- at another medical-device company he had founded, grown, and eventually sold in order to start Novoste. Often entrepreneurs who have had one success in their industry don't take the time to understand the new and different market conditions that may face a new start-up -- and the risks a lender or an investor might perceive.
Weldon knew he had to reduce the perception of "environmental" risk in the eyes of potential investors. In recent years the regulatory climate at the Food and Drug Administration has changed, and the agency has been devoting more resources to enforcement and, consequently, fewer to product approval. As a result, devices that once took months to get to market are now taking years.
Weldon believed that a lot of start-up health-care companies were underestimating the impact of that change. Though start-ups in every industry make overoptimistic projections about when they'll get to market, the FDA factor amplifies the potential for delay -- and investor disappointment -- in the health-care industry. Moreover, many health-care start-ups were basing their fortunes on breakthrough devices, which take longer to get approved than simpler, more derivative devices do.
Weldon thus pursued a two-pronged strategy. Novoste would develop both derivative and innovative products. The derivative products would gain approval and get to market faster, thus creating a revenue stream. The innovative products' passage through the FDA would be slow, but when they finally came to market, they would produce higher sales and margins. The strategy ran counter to that of many health-care start-ups that focused solely on breakthrough products in order to get into secure and profitable niches in a competitive market. But Weldon wanted to send a clear signal to investors: he had thought through the environmental risks associated with health-care reform and changes at the FDA; he had positioned his company to withstand those risks; and he was prepared to generate sales and profit in the near term, thereby assuring would-be investors that profitability was a key goal at Novoste.* * *
3. Hire a management team.
Weldon identified management weaknesses as another risk in the eyes of would-be investors, and an issue to which entrepreneurs often do not give sufficient attention. For sophisticated investors, people -- the quality of management -- always take precedence over the product.
Putting together a management team that sits well with investors is often a question of priorities and, thus, compromises. For Weldon the first priority was assembling a group that had been involved with a successful start-up in the same industry. That kind of team raises the comfort level of investors -- and raises the potential valuation of the company. Notes Weldon, "The managers have demonstrated the survival instinct."
Three of Novoste's five senior managers came from Weldon's previous medical start-up. The success of that venture gave Weldon added credibility as well.
Also attractive to investors is a management team that has previously worked together. "Management teams can disintegrate under the stress of a start-up," says Weldon. "You reduce that possibility if some of the people have worked together before." Weldon believes that attribute outweighs the risk of such an arrangement -- namely, that people who have worked together come to think so much alike that it's not good for the company.* * *
4. Raise initial financing through knowledgeable private investors.
In the fall of 1992 Weldon set out to raise seed capital to get the company going. It was the first part of a two-stage financing strategy, the second being the subsequent courting of professional investors like the Hillman Co.
Weldon's experience at his former company told him that wealthy individuals were his best bet as investors in early-stage financings. They are less proprietary and less interfering than professional investors are. Because of the higher risks associated with health-care companies, Weldon enticed some wealthy individuals by allowing them to buy Novoste stock at the same price that the three founders, who had kicked in a total of $550,000, would pay -- $1 a share. That was unusual. "Most entrepreneurs don't want to let outside investors in on the first round. They fear it will dilute them too much," says Weldon. In return, Novoste required that each private investor commit to making an equal investment ($100,000) in the second round of financing. Weldon found three investors willing to strike such a deal. They were thus in for $200,000 each. That $600,000, along with the founders' $550,000, got the company up and running to a level that could attract outside investors when additional capital was needed.* * *
5. Create a board of directors.
In assembling his board, Weldon sought balance and credibility. He put three members of senior management on the board. He then recruited two outside directors from the local community. Weldon was new to the Atlanta area, and he considered local board members a wise strategic move to raise Novoste's profile in Atlanta and to widen his own network of potential professional contacts.
Many entrepreneurs put friends or associates on their boards, without thinking through the expertise they bring -- or don't bring -- to the company. Weldon wanted to get as much talent and as broad a range of experience as he could. One outside board member was an entrepreneur who had founded a medical-device company and had subsequently sold it to a large health-care company. He had already been down a road that Novoste might well travel.* * *
6. Find technical advisers.
Before Weldon founded Novoste, while he was still at his previous company, he had been introduced to David Williams, one of the country's leading diagnostic cardiologists, and had shown him one of his former company's early products, an innovative catheter. Williams was impressed and agreed to help refine the design. Meanwhile, Weldon flew to Rhode Island once a month to look over Williams's shoulder as he tweaked the product in his laboratory at the Rhode Island Hospital. "I wanted to develop a personal relationship with him," Weldon recalls.
When Weldon asked Williams to become a scientific adviser to the new company, Williams agreed. Weldon then asked Williams to introduce him to an eminent cardiologist, Spencer King, at Emory University Hospital, in Atlanta. King also agreed to join the advisory board, as did Robert Langer, the head of the chemical and biomedical engineering department at Massachusetts Institute of Technology, with whom Novoste's newly hired vice-president of product development, Jonathan Rosen, had had a working relationship during his years at Johnson & Johnson. The three men formed a prestigious nucleus that, in turn, attracted other scientific advisers to Novoste. All three agreed to be paid in Novoste stock, again aligning their interests with those of management, employees, and investors. Their presence also legitimized Novoste in the eyes of large health-care companies, which Weldon knew he wanted to approach to distribute products for Novoste.
Weldon says that if he were in a more low-tech industry, he would still create a technical advisory board. He says it is useful for entrepreneurs to be mindful of the so-called thought leaders in their industries. Thus, even if an investor has never heard of a company or its founder, he or she might well have heard of its technical advisers and be suitably impressed. Weldon also says his clinical advisers, high-volume users of medical devices, have improved Novoste's products by "at least 15%." And that's only half the payoff. They also have suggested a number of future products worth developing.* * *
7. Create professional advisory relationships.
Novoste retained patent counsel, legal counsel, and a Big Six accounting firm, and established a contractual relationship with the Wilkerson Group, a leading consulting firm in the industry. All that further enhanced Novoste's credibility. Weldon says hiring a Big Six accounting firm is wise because potential investors "are more comfortable with the idea that you're using someone who is internationally recognized. There's no question in their minds that things will be done properly, that you are willing to pay for the best." Weldon says that hiring a Big Six firm is scarcely more expensive than hiring a no-name firm "if you negotiate hard." He signed a five-year contract with Ernst & Young. He says that for the first two years his fees are "astonishingly cheap -- less than $5,000," although they rise after that on the assumption that by then Novoste will be better able to afford its accountant. While it is illegal to compensate accountants with stock, Weldon says that whenever possible he has taken that route with other advisers to conserve cash and align interests.* * *
8. Do some public relations.
Weldon made an effort to get publicity for Novoste. "Any company can get publicity in a trade journal or in the local media," he says. "That's different from being featured in BusinessWeek." Nonetheless, Weldon says that while he was at his former company he received mention in a number of trade journals that helped him find both investors and customers.
He sees the publicity process, like the search for investors, as a multistage one. The first stage is akin to playing out of town before bringing the show to Broadway. It's a first step toward gaining wider coverage in and credibility with the national press.* * *
9. Develop a business plan.
Weldon says most start-ups write a business plan way too soon, producing little substance and dubious projections. It's important to have the company running with the top people in place first. While venture capitalists may read just 2% of all business plans they see, they always note who is running the company. "There has to be something that jumps off the page at them," says Weldon. Pie-in-the-sky numbers "won't do it for you. You need an established history with highly qualified people." Before releasing his business plan Weldon had it reviewed by his consultant, professionally edited, and reviewed further by industry peers. That ensured conservative projections.* * *
10. Hire intermediaries to identify potential investors.
This was a fallback plan. Because of the increasingly uncertain climate surrounding health-care companies, Weldon found that by mid-1993, when Novoste was ready to go out for more money, many wealthy individuals -- his preferred funding source -- had been scared out of health-care investments. He had no choice but to approach more professional investors who specialized in health care and thus knew the risks. But making contact with those investors was difficult.
Weldon balked at hiring a middleman because it meant paying a retainer with no guarantee. But Novoste was burning about $50,000 a month in operating expenses. If he didn't hire someone, Weldon reasoned, Novoste "could be sitting here two months from now with nothing to show for it." Weldon thus looked upon the retainer as an investment.
Weldon hired two intermediaries, hoping to circumvent a problem entrepreneurs face. The venture-capital world is a small one; people know of and participate in one another's deals. Entrepreneurs don't like that because it keeps venture capitalists from bidding against one another in deals. "A true free market almost never occurs," says Weldon. He hoped to isolate members of the venture community from one another by having his two go-betweens operating on opposite coasts and by asking that they not disclose the names of firms that had expressed interest in Novoste.* * *
11. Find a corporate partner.
This was a fallback plan to the fallback plan in step 10. Weldon began talking to a number of large health-care companies as possible investors. Since Novoste's distribution strategy would be based on strategic alliances formed with those companies, they were a logical universe of partners that perhaps could take minority stakes.* * *
12. Hire a public-relations firm.
Note that this step differs from step 8, which was a general effort to get local and trade-press coverage. This step is more focused on starting to build some credibility and name recognition. Weldon retained a New York City -- based firm, Desmond Towey & Associates, specialists in serving early-stage companies, with a good record of getting clients national press.
The firm understood how an early-stage investment could pay off down the road and was comfortable taking stock as payment for its services. Since measuring the payoff from public relations is so problematic, Weldon believes in paying for PR in equity only. "If you can't get this done for noncash payment, then you should simply run your own PR campaign," he says.* * *
13. Make presentations to investors.
By this point Novoste had developed an investor presentation, and during the summer of 1993 about a dozen investors (including venture-capital firms) came to Atlanta to hear it. (Novoste had sent out more than 200 business plans, and Weldon had figured he'd be lucky if he got a 4% response rate.) A strong business plan put Novoste in a good position, and Weldon successfully persuaded potential investors to visit Novoste, rather than the other way around. That allowed them to walk through the company, to see and touch it.
Weldon knew before the angels and venture capitalists ever arrived at Novoste that "we had no intention of ever taking any money from many of them." The process allowed outsiders "to shoot holes" in the presentation and enabled Novoste to refine it.* * *
14. Review the offers and negotiate.
Weldon assessed the three offers Novoste received using two considerations: valuation (the worth assigned to the company) and terms (the conditions governing the deal). Of the three offers, Hillman's was in the middle on valuation, establishing a value of about $10 million. The low bidder valued Novoste at $7 million (too low, Weldon deemed), while the high bidder valued the company at roughly $11 million.
On terms, there was little question in Weldon's mind. The venture firm offering the highest valuation also offered the worst terms (such as an ownership stake, board seats, and other means of control that seemed too restrictive). Hillman's terms were reasonable. Notably, they didn't include preferred stock or a board seat. "Many venture capitalists insist on preferred stock," says Weldon. But he feels that having two classes of stock divorces the value of the common stock from that of the preferred, driving a wedge between the investor and the entrepreneur and raising murky issues of control and veto power.
Hillman's lack of insistence on a board seat was also unusual. "Almost all venture deals give the investors seats on the board," says Weldon. Hillman's attitude toward sitting on the board affirmed in Weldon's mind that the firm's investment stance was relatively hands-off. Weldon put Dick Johnston, the Hillman partner who had negotiated the deal, on the board anyway.
Weldon says the Hillman group was the one that best appreciated Novoste's strategy of developing both evolutionary and revolutionary products. (See step 2.) That was summed up by a key question posed by Johnston: "What are you doing to address changes at the FDA?" Weldon had the answer, and, he says, "Hillman understood that this way we could reduce our dependency on FDA timing and generate some sales at the same time."* * *
15. Close the transaction.
The beauty of the Hillman deal was that it was clean and quick. The deal closed in four weeks. While many venture funds have restrictive bylaws and finite life spans, which often make additional investments in the same company problematic, the Hillman Co. is not so encumbered. It is run by Henry Hillman, a man with $2.4 billion in his pocket, and he's free to put additional funds into Novoste at a moment's notice if he so desires.
THE SILENT PARTNER
Henry Hillman, whose company recently plowed $2 million into Novoste Corp., is not exactly a household name, though one place you'll find him is near the top of the Forbes 400 list of America's wealthiest people. This year the magazine put Hillman's net worth at $2.4 billion.
Hillman, 74, is a Pittsburgh investor with a profile as low as his pockets are deep. His most recent press interview -- reluctantly given at that -- was back in 1984. The one prior to that was in 1969. Hillman sees fame as a distraction that keeps him from doing what he does best -- using money to make more money. Ten years ago the Hillman Co. was considered the largest venture-capital company in the United States, and it's still a major -- and underappreciated -- force in the venture field.
The Hillman fortune dates from the late 19th century, but Henry Hillman, unlike many of inherited wealth, has a knack for staying ahead of the investment curve. When he assumed stewardship of the family fortune upon his father's death, in 1959, it was tied up principally in the family-run Pittsburgh Coke & Chemical Co. Hillman began selling those aging assets and looking to the future. In the early 1970s he went to Silicon Valley and saw the coming revolution in microelectronics. He linked up with one of the valley's preeminent venture-capital firms, Kleiner, Perkins, and subsequently made a number of early-stage investments in high-technology companies. Hillman exited a number of those deals before the high-tech downturn in the mid-1980s and was by then doing leveraged buyouts of more-mature companies. He had started doing LBOs with one of the technique's master practitioners, the investment firm of Kohlberg Kravis Roberts & Co., back in the late '70s, when the process was scarcely known.
In recent years the Hillman Co. has stepped up its investments in health-care companies, perhaps signaling that despite all the confusion over reform, this may be just the place for a canny investor to be.