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Step lightly when adding venture capital investments to your orthopedic portfolio
Douglas W. Jackson, MD, asks 4 Questions of Michael B. Purnell, MD, about venture capital.
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Orthopedic Surgeons often lose money investing in startup companies, although a small percentage do not. The principals in these startups prefer to raise capital without a lot of strings. They often like to entice physicians to invest early. Venture capitalists make a business out of getting good returns as often as possible, setting benchmarks and getting involved in managing the startups. I have turned to Michael B. Purnell, MD, to answer four questions to gain insight into these venture capitalists who are funding many of the medical startups.
Douglas W. Jackson, MD
Chief Medical Editor
Douglas W. Jackson, MD: What is venture capital investing?
Michael B. Purnell, MD: Venture capital (VC) is a form of private equity investing. It is typically investing in smaller start-ups or expanding companies, whose need for capital frequently reappears even in middle and later development stages. Often they focus on new technology or unique, breakthrough concepts. In this way, the medical industry, for example, nurtures innovative new products such as medical devices, pharmaceuticals and biotechnology.
Venture capitalists are professional investors who develop and oversee pools of funds that most typically invest $1 million to $5 million into these growing companies. Funds are often set up as partnerships, with the venture capitalist or fund manager as the general partner and individual investors as limited partners. As such, the funds will have an operating agreement set to expire within a given time frame or following a liquidity event. Fund managers earn a management fee of 1% to 2% annually and 20% of net profits when an investment is rolled up or “monetizes.”
Responsibility to thoroughly research investment ideas falls to the VC professionals, and those they enlist for research and due diligence who are called venture partners and/or technology advisers. Many ideas are pitched but only a small percentage of deal flow is considered suitable for investing criteria, which include: capable leadership, uniqueness of product, ability to execute stated business objectives effectively and in a timely manner and insulation from competition. Only then will a venture capital fund pull the trigger and invest.
Jackson: How does an orthopedist get involved?
Purnell: Traditionally, start-ups have been inaccessible to the average investor. New companies have often used a “friends and family” approach to seeking funds, as well as providing seed capital themselves. While demonstrating commitment to their ideas, it leaves many entrepreneurs underfunded, whereupon they will solicit the venture capital market for help.
Predictably, venture capital investing exploded with the technology boom of the 1980s. Although returns were uneven due to the inexperience of many fund managers and a somewhat recklessess excesses of IPOs, numerous prominent VC firms were established up at that time and still exist today. Many are affiliated with large investment banks and institutional money managers — vehicles which can be accessed directly or through bankers and stock brokers.
Seeking help from a professional venture capitalist with an established track record is the first step to participating in private equity. Having a particular interest in a product or concept — such as an orthopedic device or application — may also be helpful. Many ideas are fostered and contacts established by attending the vendor exhibits at regional and national meetings, talking to colleagues and technical representatives from medical industry.
Beware, however, that the path to investment success may in fact not be paved at all. Temper your enthusiasm for a new idea, and subject it to the rigors of scientific hypothesis like you do with your professional practice: Test it, research it, and have your advisors do the same. Consider yourself ready to commit financial resources to a project only if your conclusions support the hypothesis.
Jackson: What are the risks?
Purnell: Every investor knows that risk and reward are inexorably linked; the goal of prudent investing is to dissociate them. Risk in participating at the private equity level of finance includes the following:
- Undercapitalization: A great company with great potential can fizzle quickly when the money runs out too soon. Early on, significant resources are devoted to continued fundraising, detracting from the main focus of product development.
- Underperformance: Manufactured products, software ideas, real estate development, and proprietary intellectual property may all fall short of expectations when beta-tested, or when facing industry/consumer scrutiny.
- Underestimation of competition: The unique quality of a product/mission is trumped by a better one.
- Overestimation of management: Fledging companies often promise more than they deliver because key managers are less experienced, skilled, and nimble than necessary when the need to change course, rework strategies, and manage growth occurs.
- Poor deal selection: Clearly the biggest risk is making the decision to invest in what turns out to be the wrong company.
The precipitous loss of an entire fund portfolio was not uncommon during the boom/bust initiated by the March 2000 technology stock market crash. Even in a well-managed, well-researched portfolio, individual company investments may lose value more than 50% of the time. The important thing is to learn from every experience; fool me once, shame on you, fool me twice … . These are not dire warnings, they are caveats meant as guidelines to developing sound strategies for creating wealth in one of the most exciting, dynamic venues of our growing economy.
Jackson: What are the potential returns?
Purnell: The lure of private equity is eye-popping windfall profits reaching 5- to 10-times the invested principal leading to early retirement. The truth is somewhat more mundane, although with discipline and patience, it is reasonable to expect healthy returns. VC investments tend to parallel the maturation and development cycle of emerging high growth companies: 3 to 5 years will allow the big picture to come into focus. Multiple rounds of follow-on or new investing may be needed for these companies to realize their potential, become profitable or be sold.
VC firms will structure the terms of their commitment to ensure the highest degree of success; this maintains the confidence of their limited partners and assures a steady flow of new capital for future participation. Although annualized returns are expected in the 25%-40% range over this period, they are by no means guaranteed. Diversified interest in five to ten private equity deals may procure two to three big winners to counteract losses in the others. For this reason, investment in adolescent businesses should be considered only as part of a balanced portfolio.
For more information:
- Michael B. Purnell, MD, can be reached at 1335 Coffee Road, Ste 100, Modesto, CA 95355; 209-524-4649; e-mail: purnellm2@aol.com.