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There has never been a better time to be raising capital for a digital health startup with the number and size of digital health deals increasing every year. The $100 million+ funding club continues to increase as companies grow and mature. Many digital health Digital Health companies are growing to become Unicorns worth $1 billion or more. Driven by an active M&Amergers and acquisitions environment, companies are able to raise capital, grow fast and provide liquidity for their investors. At the same time, with more and more digital health companies getting funded, it is getting harder to stand out from the crowd and digital health startups will have to show a strong awareness of activity in their space and present a clear differentiation from the rest. Understanding the early stage funding environment is a critical step towards success, and yet the process and language of venture capital are unfamiliar to many. In this chapter we’ll cover some of the main points that lead to successful early stage digital health funding including the stages of funding and milestones, sources of funding, capital strategy, exit strategy, valuation and term sheets.

Sources of Funding for Digital Health Startups

Digital health startups are well poised to raise the funding they need for growth because of an active investor community in this space, great acquisition/exit environment and an industry that is hungry for innovation. We will review some of the most popular sources of capital for digital health companies at every stage of their growth.

The earliest stage digital health startups still typically operate in bootstrap mode , raising money from friends, family and founders. While working towards development of a prototype or MVP (Minimum Viable Product) startup founders often keep their day jobs to pay the bills and work on their startup at nights or weekends. Additional cash resources may come from savings, credit cards or HELOC (Home Equity Line of Credit) from their bank. While the startup company itself will not qualify for funding, the founders themselves may have access to capital through these sources.

There is a caveat to using debt as an early stage funding source for the company. Angel and Venture Capital investors typically want their investments to go towards growing the company and will rarely allow founders to pay themselves back for the debt they may have incurred either from themselves or friends and relatives. An amortization schedule of 12–48 months is typically acceptable, so early debt investors should be prepared to be patient. Additionally, many founders are asked to convert their debt into equity, so it will be a long path to liquidity which should be considered before going down that path.

SBA (Small Business Administration) loan guarantees are another way for early stage companies to borrow money for their startup. The SBA effectively provides a loan guarantee to a local bank whose risk is significantly mitigated because of that. Many banks will still want to see your company as being close to positive cash flow before they will make the loan however, so that they know you will have the ability to pay off the loan. In addition to the caveat made earlier about investors not wanting to repay early debt, you should also be aware that SBA loans come with personal guarantee requirements, so you are personally on the hook in case of failure of the company and default. This additional risk to founders personally may make sense if they are the only owner of the company, but can be unfairly burdensome when stock is sold and others own the company and benefit from the use of the capital, but without their own personal risk.

Grants are a common source of early stage funding for digital health companies. SBIR (Small Business Innovation Research) grants are quite common. These grants range from $150,000 to over $1 million for different phases of research. The purpose of the grants is to outsource federal research and development expenses to companies with a strong likelihood of commercializing the technology. SBIR grants are issued through federal agencies such as the department of Health and Human Services, National Institute of Health, the National Science Foundation and others. STTR (Small business Technology TransfeR) grants provide funding for technology transfer from research institutions and can be a good source of early funding for projects coming out of U.S. research institutions.

The main things you need to do in order to be successful with grants is to become familiar with the granting agencies and develop relationships. Grant applications from parties unknown to the agencies are rarely granted. Additionally, grants work according to a strict calendar, so start early and get your ducks in a row. Finally, letters of support are crucial for success, so think through your reference strategy carefully.

In addition to federal grants you should also be looking at local economic development grants closer to home. These grants often require “matching funds”, meaning that you need to match the grant dollars with dollars from other sources including revenue, investment or other grants. Some companies with strong grant strategies can create a domino effect when one grant is offered, two or three others may become activated.

Crowdfunding for either equity or “rewards” can work with some digital health companies, especially if the technology centers around some consumer oriented product such as wearables or fitness trackers. Rewards crowdfunding can be more effective in gauging consumer interest in a product than in actually raising capital. Being able to point to greater than expected consumer adoption is a great traction point that companies can use in their angel or venture capital pitch later on. The lure of crowdfunding can be great because it looks so easy from the outside. Be aware that it can cost tens of thousands of dollars to put together a crowdfunding campaign. Successful campaigns involve investors you already have in your network vs. investors who are registered on a platform. Additionally, if you are raising capital from an equity crowdfunding platform you should be aware of the dangers of taking on non-accredited investors or even large numbers of accredited investors. Both of those can be a red flag to VCs, many of whom will not want to join a capitalization table with so many other people. If you do use equity crowdfunding of any kind, be sure to have all the investors put their money into a Single Purpose Vehicle, an LLC that is a holding company for their investment, so that only one entity will show up on your capitalization table.

Accelerators can also be a source of funding for digital health startups. There are “horizontal” accelerators like TechStars that focus across technology in multiple industries. Other accelerators like Rock Health, Startup Health, Blueprint Health, Healthbox, TMCx, New York Digital Health Accelerator and many more are “vertically” oriented and focus just on digital health and/or healthcare oriented companies. Accelerators often contribute $25,000–$125,000 to their participants, usually from an accelerator fund, and also host a “demo day” for participants to pitch to the community of angel and VC investors for more capital.

Angel investors will typically look at a digital health startup when it is at the MVP or prototype stage. Angels will typically see their money used for putting finishing touches on technology and getting your company into some pilot projects with healthcare providers, or test your marketing channel strategies. When angels invest as individuals the typical investment range is between $25,000 and $100,000 per investor. When angels invest in groups, the typical range is $500,000–$1 million.

Many people confuse angel investors with the friends and family investors who invest early in the company. Angels think a lot more like venture capitalists than they do like your friends and family. While friends and family will invest primarily in you, the angels are investing primarily to make a profit. They will want to see a clear path to exit which provides them with at least ten times their money in return, with the possibility of up to one hundred times returned.

Angel investors present themselves in several ways, but one big distinction is that some angels are lone-eagles who invest on their own and others invest through angel groups. There are hundreds of angel groups across the U.S. Canada, Europe and Asia. You can find many of them on the Angel Capital Association website (www.angelcapitalassociation.org). The benefit of working through an angel group is that groups typically do their due diligence once all together and help angels make decisions to invest with having the entrepreneur go through “Groundhog Day” (as in the movie with Bill Murray) and having to go through diligence over and over for each investor. Additionally, many angel groups syndicate with other angel groups, so if you make the right connections, you can get your company funded by the collaboration of many groups investing together. Syndication is basically the process of one or more investors investing together on the same deal terms.

Family Offices are another source of capital. These act almost as a super-angel, doing their own due diligence and investing separately or through groups or syndicates. Family Offices have millions to invest, but often have only a small portion of their assets allocated for startup investments.

Venture capital is an option once you’re well into revenue. Seed stage VCs may look at your deal in a pre-revenue stage, but getting to Series A, which is the first round of institutional venture capital, typically takes revenue in the $1 million–$2 million per year range. Series A investments can range anywhere from $3 million to $10 million dollars today.

You should begin developing relationships with venture capital funds up to a year or more before you actually need the money. VC is a relationship based transaction and they want to know you for a while and see how your company performs against its goals. If you meet with a VC and let them know your expected milestones for the next six months, it’s a good strategy to over perform and come back six months later to show how you are able to execute. This extended relationship is actually a part of many VCs due diligence strategies. By watching your performance over time, they can get an idea of how well you’ll execute once they have invested.

Corporate Venture Capital (CVC) has become a powerful player in the venture capital world and now accounts for over 25% of all venture capital investments. There is a particularly high amount of CVC action in the digital health space as institutions and healthcare companies are looking towards venture capital investments to keep their fingers on the pulse of the industry and to tap into new technologies. There is a saying that “M&A is the new R&D”. This means that while research and development expenditures from major companies has been on the decline for many years, CVCs are investing in early stage companies to help fill their pipeline for mergers and acquisitions. It is easier, cheaper and faster for companies to bring on new products and revenue by acquiring companies rather than developing new technologies in house.

Keep in mind that working with CVCs is a two edged sword. On the one hand, having a “strategic” investor can provide you with faster growth, if your investors become customers, and on the other hand there can be a problem with “signaling” if they are on your cap table (a table showing all investors in your company) and they choose not to acquire you. When other companies are going through due diligence when looking to make an acquisition offer for your company, they will be wondering what the CVC knew after having sat on your board of directors for years and having decided not to acquire you. There may be perfectly good reasons why they did not choose to buy, but regardless it sends a signal to others that there may be something wrong with your company.

ICO or Initial Coin Offerings are a new way for digital health companies to raise money, especially if their technology is in some way blockchain enabled. There have been many successful ICOs and the average ICO last year was about $44 million. There are many strategies for raising money using an ICO and the SEC (Securities Exchange Commission) is developing more transparent guidelines about whether “tokens” which are sold in the ICO are securities. There is too much detail to go into here, but if you think this could be a good source of funding, do your research first!

Other sources of funding include factoring (accounts receivable finance), purchase order lending, other asset backed lending, revenue sharing (for companies with positive cash flow), and asking your customers to become investors—both by buying your product or service, and also by making a direct debt or equity investment in your company.

You may want to think about all of these funding choices as a suite of tools to serve your capital needs. You do not need to choose just one type or another. You can mix and match the most effective sources for capital for your stage of business and capital use needs.

A Tranching strategy is a good way to minimize your dilution as you raise capital. Regardless of the source of capital that you choose, you will want to think carefully about your capital tranching strategy . Tranching is basically the process of breaking up your total capital needs into phases. By raising only as much as you need to reach your next major milestones (and a little extra buffer since it will likely take you longer than you thought), you can minimize your dilution and make it easier to raise each round.

Most startup capital raises are enough to fund 12–24 months of runway. But it’s not just about the amount of time you need to fund, you also need to be aware of the milestones you need to hit. For example, if you are raising a seed round which you hope will take you to a Series A venture capital round, then you should make sure that your raise will be sufficient for you to build your sales up to $1 million or more in annual revenue run rate.

Valuing Your Digital Health Startup

While valuing a pre-revenue startup may seem difficult or near impossible to many, this is something that is done every day and there are good tools to get you to a valuation number that will be satisfactory for both investors and entrepreneurs.

The first thing to realize when you’re valuing your company is that the goal is not to come up with a number like $3,257,456.67. There is no process to get to a number that exact, and even if you could, negotiations for early stage equity are typically done more in round numbers. In fact, our goal is to come up with a satisfactory “negotiation range” in which there will be a fair deal for both founders and investors.

Many people think that you can’t value early stage pre-revenue companies and that instead of doing a “priced round” in which the valuation is clearly negotiated and investors invest in stock in the company, some people think that you can escape valuation by using “convertible debt” (a note payable that has a provision for conversion to equity at a set time or when a qualifying funding round occurs.) Just using a convertible note does not get you out of having to value the company. One of the main terms of the convertible note is the “valuation cap ” or the value above which the conversion price will not go. So, if the valuation cap on a convertible note is $3.5 million, then the investor is likely to end up converting to stock at a later date at the $3.5 million price. So, obviously, if you use a convertible note, you still need to go through the valuation exercise to determine the valuation cap. The simple formula for calculating the valuation cap and better understanding the difference between the company valuation cap and the company valuation is shown below. (Hint: they are the same.)

$$ \mathbf{Valuation}\ \mathbf{Cap}=\mathbf{Equity}\ \mathbf{Valuation} $$

Valuation and negotiation in the venture capital world is not like it is in other types of commerce where the buyer wants the lowest price and the seller wants the highest price. In VC the best deal is the one that is most fair for both parties. If the price is too low, then there will not be enough dry powder equity available for future rounds of investment. If the price is too high then there is a risk of a “down round” where the share price in the next round is lower than the previous round, resulting in significant dilution for the founders.

The process of finding the negotiation range involves using multiple valuation methods. Think of this as an uncertainty reduction exercise in which your job is to start with great uncertainty and then, by applying several valuation methodologies, reducing uncertainty down to where you have a reasonable negotiating range.

The methodologies that you use are rarely satisfactory for coming up with a valuation on their own. Each has its own challenges and imperfections, but when used together, it actually works. Think of these as five drunks in an alley who can barely stand up on their own, but who, when working together manage to stand up. That’s why we use multiple models. Another reason for using multiple models is that we are tackling the question of valuation from multiple viewpoints. It would not make sense to do five different DCF (Discounted Future Cash Flow) models , because they would all use the same inputs and would likely reproduce the outputs of each other. In our case we will recommend models that use DCF , models that use risk adjustment, models that are finance based, and models that are based on comps, much like a real-estate appraisal. By attacking the question of valuation from multiple angles, we get a fairly comprehensive view of what creates value in a startup company.

Here are a few samples of valuation methodologies at work. We don’t have enough space to do them all, but these should give you a good idea of how you can get a good valuation even if the company is not in revenues yet. Note one benefit of using models like this is that when you are negotiating your deal you have supporting data to support your arguments. Investors and founders can negotiate on the assumptions vs. the Big Number all by itself.

The Venture Capital Method

The venture capital method comes to a valuation number by working from the exit and backing into a valuation number. This is a DCF (Discounted Future Cash Flow) method because we’re going to model what a likely exit scenario is and then apply a venture capital discount to that to determine the value of the company today.

You can see in Table 6.1 that the Exit Year, Revenue at Year Five, Price to Revenues Ratio and the Exit Valuation are all working together to create the number from which we are going to be deriving our present day valuation. If the revenues are $10 million at year 5 and the standard exit valuation is 5 times top line revenues, then the exit valuation in our model is 5 times $10 million, or $50 million. Now we apply our discount rate of 60% IRR (Internal Rate of Return—IRR is effectively an interest rate that compounds over five years. One dollar invested at 60% IRR will yield about $10 dollars in 5 years). The discount multiple is based on the lack of liquidity for the investment, lack of control (since angel/vc investors are typically minority shareholders), and the extraordinary risk in investing in tech startups.

Table 6.1 Venture capital valuation method
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While coming up with the year five revenues in your proforma financial projections can be difficult, and researching the common price to revenues ratios can be difficult, doing the math for this method is easy. What number times ten equals our exit valuation? The number is $5 million. That is our post-money valuation (the valuation of the company including the investors capital contribution). Now we subtract our investment of $1 million and come up with the pre-money valuation of $4 million. You should always use the pre-money valuation when talking to investors.

You will note that the Venture Capital Method only works on deals that have one round of funding. Other models will allow you to model valuations after Series A, Series B, etc. and will help you to calculate cumulative dilution for both founders and investors.

Dilution is not as bad as most entrepreneurs and investors think. If you mistakenly believe that owning 1,000,000 shares of founder stock and selling 25% of the company means that you have 750,000 shares after the transaction, then you would be justified in being worried about dilution. Instead, the founders will always have 1,000,000 shares of stock, and selling 25% of the company means that they are issuing 333,333 new shares of stock. Since 1,000,000 is 75% of 1,333,333 the founders keep their stock and dilution is not as bad as they thought. Additionally, any further rounds equally dilute first round investors and founders, so the dilution effect is shared. The average angel investment round in the U.S. is about 23.5%, but the investment range can vary widely from deal to deal.

The Scorecard Method

The scorecard method works like a real-estate appraisal. To do a real estate appraisal, the appraiser researches recent comparable transactions in the neighborhood. The appraiser then adjusts the prices up or down compared to the target house based on factors such as total square footage, number of bedrooms, number of bathrooms, granite countertops, etc. The scorecard method works much the same way. We start by researching the average startup value, then adjust the valuation up or down based on the key factors that impact startup valuation such as Team, Opportunity Size, Product, etc.

To use the Scorecard method shown in Table 6.2, you first need to research the average valuation for seed rounds in your industry. Last year the average was about $3.65 million nationwide. You can find this information from a variety of sources including the HALO Report, Crunchbase, Pitchbook or CB Insights among others.

Table 6.2 Scorecard valuation method
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The Value Drivers and Weighting stay the same for every valuation. Team, for example, is always 30% of the value. It should be surprising to anyone that this is the most important driver.

The actual valuation exercise is in the Score column. If all of the rows were set to 100%, then the company would be average in all ways and the multiplier would be 1.0 and the valuation would then be $3.5 million (or whatever you used for your average for digital health startups). But companies are not all alike and this is where we score them. For the Team driver, 100% looks like three developers and a dog. If they have more people, then they would go up to 150% and even higher for a big team. It’s not just about quantity of course but getting a lot of people to quit their day job to join your team is a significant validator of the quality of your company and demonstration of traction. On the other hand if you had only two people, then the score might be 50–75%. If you had a CEO with multiple $100 million exits under their belt, and a full team of highly qualified individuals, with all of the main areas covered (finance, strategy, marketing, technology, etc.) then it might get to 400%. Once you have entered all the scores, then you would multiply the score by the weighting and add it all up to get your valuation multiplier which you would apply to your baseline valuation to get your final valuation.

The Scorecard method is a good way to help you get through negotiation, but it takes a lot of experience and comparisons to other teams before you can do this one well. It does have a lot of subjectivity to it, but when used along with the other methods, it is quite valuable.

One last word on valuation. Now that you have an idea about how to calculate the valuation of a company, you should also know that the valuation of the company is not necessarily the same as the price for that company. One of the first digital health companies I ever invested in had a price that was easily $1 million less than the valuation that I got when I ran these models. I told the CEO that I had come up with a higher valuation and he told me that he knew the value was $4 million, but he was pricing it at $3 million because he had two pilots launching in 3 months and he needed the capital quickly to make sure that all the development work was done in time for the pilots. Indeed he raised the round in just a few weeks and the two pilots launched successfully and on time. The company is now worth more than $54 million and continues to grow very quickly. If he had priced it at the value of the company, it would have taken a few months and the opportunity window for the pilots would have closed.

Exit Strategies

Digital health startups are getting funded fairly easily today in part because there is such a robust M&A market for digital health companies. Established companies are buying up digital health companies for a variety of reasons and they are paying higher and higher multiples for them. Having a strong exit strategy is almost a necessity for raising capital today.

Just being a good digital health company is not enough to grab the interest of investors and then ultimately acquirers—you need to have a well-articulated exit strategy to maximize the value of your company. We’ve created the Exit Strategy Canvas to help you work through the exit value proposition and timing so that you can present the strongest story to your investors. Many investors will not admit it, but the exit strategy is the number one filter for whether they jump into a deal or not. It should be no surprise that having a well thought out strategy for returning the investor’s money would be helpful in getting them to write a check.

Many people struggle to state their exit strategy and will resort to generalizations like “we’re going to shoot for M&A or IPO”. This is NOT a strategy and will do little to engage your investors. The six sections of the Exit Strategy Canvas will help you to find the elements of a strategy which can then be used to create your exit story.

Industry Vectors is the first segment to complete . A good CEO is also a good Futurist and should have a deep knowledge of his or her industry and the vectors that are impacting the future of the industry. Vectors could include “rising cost of healthcare”, “problems with uninsured people,” “changes in regulations”, “competing technologies”, “rapid growth of IoT”, “blockchain”, “DNA sequencing”, etc. Another way to look at the Industry Vectors is to watch what the incumbents are doing and where their pain points are. What pain points now will be even bigger for them in the next three to 5 years. If you build your strategy by thinking about what the potential acquirers need rather than just the customer’s needs, then you are a step ahead of your competition.

Values are the next thing to consider. If your goal is to be acquired, this is a relationship similar to getting married and you should make sure you understand the values of your organization and to find ways to ensure that your potential acquirers share those values. A significant amount of M&A transactions fail and a failure to match values is one of the biggest causes.

Recent Comparable Transactions are your next section to complete. Here you will report your research on acquisitions, showing who the acquiring company was, who got acquired, what the dollar amount of the transaction was, what the sales price was as a multiple of revenues and a summary of the acquisition strategy. Collecting this information tells you several important things. First, you learn about where the sweet spot is for acquisitions. You will find some outliers and digital health has certainly had a good number of unicorns (private companies valued at $1 billion or more) which are typically outliers. You will find that companies like yours will mostly be acquired within a certain zone like $100 million–$150 million. This helps you to develop your strategy and populate your proforma financial projections you give to investors. If, for example, you find that companies like yours are being bought for five times revenues and average $100 million, then you know that your target revenue run rate to have an optimal exit should be around $20 million.

The second thing you learn in this space is what the revenue multipliers have been. If you create a value oriented strategic plan, you may be able to sell at the higher end of the multiples you find. If you just build a company that focuses on customers but not the acquirer, then you may end up with lower multiples. I call this principle the “second customer” principle, meaning that you need to simultaneously build your company to serve the first customer who buys your digital health product, and also to provide maximum value to your “second customer” who buys your company. These value propositions are not the same and should be considered simultaneously in any important strategic decision.

You will find that it is difficult to locate much of this information. If you have incomplete information on some transactions, that is ok. Go ahead and use them to fill out the table. Some information is better than none at all. You can find some of this information in the SEC EDGAR database online, or at Pitchbook, CBInsights, Crunchbase and other data sources (Table 6.3).

Table 6.3 Exit strategy canvas
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Your Team is the next section. The team is NOT the same team you might have on a pitch deck slide. You should identify the gaps in your team that need to be filled to achieve an optimal exit. These people may be consultants or advisors, or they may be full time on your staff. Examples include lawyers, accountants, investment bankers, CEOs with exit experience, etc. By identifying and engaging these individuals now, you can use them to build your exit strategy as well as to execute on it.

Exit timing is one of the most important issues to consider because you never know when an acquirer might come knocking on your door. You should be thinking about your value proposition to acquirers and how that changes over time. Early on in your startup, the value may be for the technology, patents or employees (an “acquihire” is an acquisition just to get your team). You should be thinking about that value proposition as it evolves to include customers, distribution channels, cash flow, new technology or other competitive advantages. It’s a good idea to always know what your company is worth, so when an offer does come along, you know if it’s a fair one or not.

Exit Targets is the final segment to complete. You will want to identify who are the likely acquirers of your company. You should identify not only the company that will do the acquiring, but the people inside the company who will lead the decision making process. This is different for all companies, so you may need to do some research. In some cases it comes from the CEO or CFO, others have strategy departments, M&A groups, corporate development teams, or product managers.

Once you have identified the people you need to know, it’s time to do some research. Get on LinkedIn and connect to them. Join the LinkedIn groups that they are members of. Find out what conferences and trade shows they attend. Read their blogs and find out how they think. Write your own blogs and send them to your contacts. Be a thought leader in your industry and get known for that. M&A is much like venture capital because it is a people oriented business. Corporate Development teams like to get to know you six or twelve months before they consider making an offer, so starting the relationships early on in your company life-cycle is a really good idea.

Once you have completed the Exit Strategy Canvas, you can use it to help make decisions, make a better story for your pitch deck and to drive alignment between your team members, board members and investors. One investor I know asks to have a review of the exit strategy at every board meeting. It does not need to take a lot of time, but it ensures that everyone is still on the same page for this important piece of your company’s strategy.

Remember, exit strategy is the number one filter that investors have for making investments, so having a well-researched exit strategy is your best strategy for raising capital for your business.

There are many other factors for you to consider in your fundraising strategy including putting together a killer pitch deck and presentation style, building a team, developing a prototype or MVP of your product, getting your legal house in order, preparing for due diligence so it goes smoothly, refining your strategic execution plan, validating your customer value proposition, writing up a draft term sheet so you’re always ready to close on an investor meeting and much, much more. We have covered some of the more complex topics here that apply especially to digital health startups and there is a wealth of resources that serve the needs of all startups that I would encourage you to become familiar with.

Funding your startup is hard—good luck!