Physicians delve into startup funding

Physicians are riding the digital health wave, investing in startup companies long before they reach the public stock markets as technology and regulation disrupt the healthcare industry. Some physicians see the deals as financial investments, others see them as potential future careers, but all of them should keep the significant risks of early-stage companies in mind before jumping in, experts say.

Investors as a whole poured $2.5 billion into digital health startups in the first quarter of 2017, according to StartUp Health LLC, which invests in early-stage companies and promotes technological advances in health. These companies make software, data applications, and other tools for a huge variety of healthcare goals, from tracking health and patient outcomes and improving EHR to mining big data to pinpoint the causes of disease.

Among StartUp Health’s investments are Arpeggi, a gene sequencing company, and Avado, a patient relationship management platform that was acquired by WebMD.

It’s easy to understand the caution: Startups funded by angel investors had a 70 percent failure rate, according to a 2016 industry report sponsored in part by the Ewing
Marion Kauffman Foundation. Angel investments are funds that invest in startups in exchange for equity or debt.

While the Kauffman study looked at deals across several industries, healthcare startups face specific challenges, often including the need to be adopted by large hospital networks, experts say.

Tobin Arthur, chief executive officer of Seattle-based crowd-funding platform angelMD, aims to improve investors’ success rate by connecting accredited investors (those with $200,000 in annual income or net worth of $1 million), to digital health startups. Most investors using the platform are physicians who are also asked to share their practice experience with startups seeking funding, though that’s not required, he says. 

Fostering relationships with healthcare players, including physicians, he believes, helps lift the companies’ prospects for survival while potentially rewarding investors.

Given their incomes, physicians often are asked by family members or friends to invest in all sorts of business ventures outside their medical expertise, he says, a process that can end badly.  “When people invest in what they know, the batting average goes up,”
Arthur says. 

Physicians thinking of exploring healthcare startups need to understand the risks, explore potential legal issues, and be realistic about the time it will take to realize any gains, experts say. 

Next: Assessing the risk

Assessing the risk

Not surprisingly, financial advisers urge physicians to exercise extreme caution when considering investing in startups.

New York financial adviser Alina Parizianu, MBA, CFP, says clients have different capacities and tolerance for risky investments, but as a general rule she suggests keeping startups below 5 percent of an investor’s portfolio. “You see more and more brilliant ideas these days, but which one is going to be the profitable one? No one knows,” she says.

The difference between capacity for risk and risk tolerance? A young, very wealthy individual might have significant financial resources and a long time horizon to weather periodic losses. That person might have a high capacity, or ability to take risks. But if the person has a fundamental fear of risky assets, advisers say their risk tolerance is low. 

Physicians’ incomes-typically high enough to qualify as accredited investors but not so high that they are involved in venture capital financing-position them for more of the “friends and family” and angel investor networks. 

Wayne Chen, MD, a geriatrician, invested in a friend’s startup, a static resistance
device geared to seniors, more than two years ago and serves as an adviser to the company. “For me, the operational experience is a big part of the value,” he says, referring to new career opportunities outside traditional medical practices that the ventures can present.

“My wife and I talked it over extensively to make sure we weren’t investing more than what we could comfortably lose and that it wouldn’t impact our yearly budget. From there, I looked at it as a learning process as much as I did an investment,” he says.

Where to look

Finding early-stage digital health startups is fairly easy today. Many cities have startup incubators and there are several networks of angel investors specializing in healthcare online. Some angel networks now market startups to university alumni networks, and some medical societies are starting to explore partnerships with investment networks.

AngelMD, Arthur’s crowdfunding platform, matches investors (mostly physicians) with healthcare startups. An unrelated group of more than two dozen physicians have formed an angel-investing network in Chicago called MDAngels. Founder Jay Joshi, MD, MBA, launched the network with his own startup, Output Medical, a device for improving urine output measurement for patients with kidney disease. Joshi also runs a solo primary care practice in Munster, Ind.

The MDAngels investor group meets quarterly in Chicago and thus far has invested an average of $85,000 in a handful of startups. Joshi’s advice: Physicians should think like entrepreneurs, not investors, and get involved in operations so they can positively impact the success of the company. “I’m actively involved in these companies, referring them to hospitals and nursing homes that I know and networking with other physicians,” he says. 

Next: Vetting ideas

Vetting ideas

Whether physicians envision setting a new career course by working with a startup, plan to use the product in their practices or just want to diversify a portfolio, experts say robust due diligence is in order. When Chen was approached by a friend to invest in the device company, the friend also asked to help with product development, marketing, and company operations. He asked the company’s two founders detailed questions about the data in their slide presentation pitch to investors, but didn’t pick up on some underlying disagreements between them. The original partners have split up and Chen, still an adviser, is re-negotiating equity terms of the partnership.

Ask startup founders how they will accomplish the day-to-day operations and bring the product to market, particularly if they are involved in companies in addition to the current venture, Chen recommends.

And even if the product is in a physician’s own specialty area, Chen says it’s important to run it by colleagues. For the portable resistance device, he validated the idea with physical therapists who work with seniors.

Internist Jennifer Meller, MD, MBA, who recently founded her own startup venture, agrees. “Just a great idea isn’t enough,” she says. “You have to evaluate whether these are people who can execute an idea.”

Patience is key

Physicians ready to explore startup investing further should be realistic, patient, and diligent about the details. Experts advise the following:

Set expectations

Private investors, even if they are silent partners, need to set out their expectations for how frequently the founders will report on product development, operations, and marketing issues, Chen says.

Investors also need to embrace realistic guidelines for any potential payoff. Just 30 percent of startups in the Kauffman study logged positive returns for investors. Among those, about 5 percent saw significant gains, returning more than 10 times their original investments. 

“Sometimes original investors barely make anything,” says Carrie Coghill, CFP, AIF, president of Coghill Investment Strategies in Pittsburgh, an investment firm with several physician clients. 

Be ready to wait

Chen also recommends setting a much longer time frame for product development than founders typically envision. “Our timeline was three years, but we ran into production issues overseas so that is maybe five years now,” he says.

Angel investments in the Kauffman study averaged 4.5 years from initial funding to exit, either through a purchase or an initial public offering, though industry experts say the timeframe can exceed seven years. 

Curb enthusiasm

Even if the investment represents a very small portion of an investor’s total assets, experts often recommend scaling back the initial outlay. Parizianu cites a physician client who was asked to invest $50,000 in a friend’s startup. She felt the company was a little unrealistic about growth prospects, so she recommended investing half that amount until some benchmarks were reached. 

Deal with legal questions

Hire an attorney to review any contracts associated with the deal, Parizianu says. It’s critical to understand the subordination agreements that govern priority standing among investors, she says, because they spell out how initial investors will get paid once the company is sold or goes public. If the investments involve debt instead of equity, creditors need to know where they will stand in line for possible repayment in the event of bankruptcy.

Beyond the specifics of ownership in the investment are a host of legal and ethical considerations, says Reesa Handelsman, JD, a partner with law firm Wachler & Associates in Royal Oak, Mich. She typically recommends consulting tax and securities attorneys, as well as healthcare attorneys familiar with federal and state referral and anti-kickback statutes.

Even if the investment is an early-stage startup with no direct connection to patients yet, it’s important to think about how it will look in the future to anticipate possible conflicts of interest down the road, she says.

Any prospectus or documents a startup provides should highlight potential legal risks to discuss with an investor’s own attorney, she says. Will physician investors be personally referring patients or getting involved in other ways to generate business? If so, physicians need to consider their payer mix and whether their contracts prohibit that kind of activity.

As a rule of thumb, she adds, physicians should be sure they are paying fair market value for their investments to avoid the appearance of being given a stake in exchange for referrals.

From an ethical standpoint, she says, consider if the venture raises any concerns about over-utilization of health services or creates an incentive for unnecessary services on the part of the physician.

Study the competition

Another common trap for investors is assuming they are the only ones thinking about their business opportunity, Coghill says. “They get really excited about an opportunity without realizing someone with much deeper pockets might come along.”

Finally, consider the personal credibility of anyone involved in the deal, says Chris Chen, CFP, chief executive of Insight Financial Strategists in Waltham, Mass.

“Financials always look good because they are contrived to look good,” he says. In other words, treat any future projections with skepticism. “Beyond that, look at whether the principals are properly motivated and have credibility from doing this work before.”

Physicians should trust their own industry knowledge says Meller. “They bring a different perspective to the table,” she says. “They’re going to poke holes and key in on what they think is interesting about an idea,” which may be completely different than what a founder thinks.