Startup Funds and the Funding Gap
Why early and small investment rounds are difficult to raise
By Michael Schmanske
[ORIGINALLY APPEARED IN MDNEXT Q4-2022]
Currently, the oral health industry is severely underinvested with innovation opportunities often left on the table. Revere Partners is hoping to change that as first-movers in the space.
Revere invests with two major timeline-based categories in mind: short-term prospects and long-term prospects.
Short-term opportunities already have integration and are being used with significant underlying whitespace. The capital employed is primarily for growing the company and a great deal of effort is put toward sales and marketing. These companies are often derived from achievements and have some foundation.
Conversely, long-term prospects are sometimes no more than viable concepts. These types of ventures require a great deal of thought, expertise and manpower for testing the viability of innovation. They offer much greater long-term reward prospects but also hold a great deal of risk stemming from uncertainty in more milestones toward success..
Whether short or long term, the future looks especially bright in the oral health space. When the combination of industry experts is adjacent to the strategic capital and earnest deployment pace, the results are prime to perform—even during a recession. Dentistry has always fared well in economic downturns. In the 2008 recession, patients continued to visit the dentist and the industry thrived. We do not expect any different in the coming years.
What we are looking for right now
“We see gaps within the industry as well as synergies, and bring several solutions together to form a more comprehensive and/or operable whole,” says Revere managing partner Dr. Jeremy Krell.
Simply put, Revere takes a thematic approach to investing—breaking oral health into subcategories that complement each other to solve a previously unsolved challenge where it believes there is big upside value creation and investment potential to this strategy.
Yet how does this thematic approach benefit investors? Essentially, Revere has to anticipate market risk—not just product risk in dentistry, that is, the go-to-market strategy and consumer/provider adoption. A recent article in the Harvard Business Review states: “Strategic opportunities for new ventures can be categorized along two dimensions: attitude toward incumbents (collaborate or compete?) and attitude toward innovation (build a moat or storm a hill?).” Revere couldn’t agree more.
For fintech, that challenge has traditionally been payment solutions that take limited payment mechanisms, as well as the merchant processing fees shaving percentage points of the practice’s revenue. Other frustrations included financing with high interest and low approval rates, wait times of hours to weeks to confirm insurance benefits, and claims that “get lost” in the practice’s priorities, leading to lower than initially expected reimbursement without knowing it.
The microbiome is another area ripe with innovation—educating the patient, quantifying the problem, and devising a precise therapeutic, delivered in a platform they like to use. Startup Bristle Health uses genomics to measure the “good, the bad and the ugly,” and provides coaching and personalized care plans to help improve oral health. BrickBuilt Therapeutics uses live biotherapeutic products for the prevention and treatment of periodontal disease, caries (cavities) and oral candidiasis (thrush). And, Twice combines cutting-edge science and clean ingredients to create a holistic oral health system for a healthy mouth. Lastly, startup Lura Health has brought the world’s first salivary diagnostic, wearable sensor to market, allowing for ongoing biometric monitoring (more details on some of the startups referenced above can be found in our “Top Picks” beginning on p. 46).
Being specialty focused provides an advantage as subject matter experts when selecting optimal investments. But it also helps with post-investment support and strategic partnerships. Every situation is unique, but lately, Revere prefers collaborating and building a moat. If the company sees that a product or service is part of a set of parallel or sequential solutions, then “vertically investing” can be a strategy that pays off with an end-to-end solution that drives value to its target market across the continuum.
Clearly, the oral health space is rich with bright ideas and innovation, solving problems that benefit patient, practice and investor. While not the first area you might consider as an investment or startup space, this space has proven to be an especially exciting arena in which to invest, grow and bring change for the better.
Family offices are groups of one or more wealthy families that manage their assets like an established hedge fund or other Asset Manager. They probably support a series of trust funds and/or charities. Think about the Waltons from WalMart, the Koch Brothers or Jeff Bezos’ private accounts. Now scale down to the local property developer or mall owner. Family offices may be anywhere in the range of $50 million to $5 Billion AUM. They are different from private endowments or foundations primarily in their internal structure. They answer to a small board of family members or an individual rather than a larger group of more conservative executors who themselves normally hire an external consultant for plausible deniability if an investment goes south.
The Funds Gap
Consider the structure of an institutional asset manager. They charge 2% on Assets Under Management (AUM). So a $250 million fund generates $5 million/year in fees. Operational and fundraising expenses take away ~ 40% of that leaving $3 million for compensation. An institutional PM doesn’t get out of bed for less than $1 million/year and they need a research and support team that costs ~half of their pay. So with $3 million of net fees available for compensation expenses, we have two teams at $1.5 million each that we can support. How many companies can each team cover? It depends on their philosophy. Some funds have adopted a scattershot approach: Let’s say they can cover 100 mostly hands-off investments. Liken them to the Skinny Syndicate from my earlier posts. A hands-on team might focus on a more manageable number like 25.
OK skinny syndicate fund: $250 million AUM, 2 teams, 100 companies each = $250 million/200 yields an average check size of $1.25 million. Investors do not like that format. The scattershot approach means very little direct support or management interaction with the portfolio companies. Add in the 2% per year management fee to sit and watch, and that is a big performance drag. Exits are ~ 5 years for many early stage companies and could be as long as 10 years. That’s 10–20% off the top for a hands-off strategy. No thanks, I’ll take the monkey and the dart board again. As a result, while these structures do exist, they are primarily family office operations that have launched a coinvestment fund to try and cover a share of their sunk costs.
What about that more closely watched and held managed fund? It has $250 million in AUM, 2 teams, 25 companies each = $250 million/50 or an average check of $5 million. You see where I’m going with this. Even the skinny fire-and-forget fund writes checks between $1 to $2 million. The managed fund won’t get involved until $5 million. The biggest reason that checks do not get easily written in the $250,000 to $2,500,000 range isn’t the companies’ fault. It is because there is little or no institutional appetite for that size of investment. There are also style and ego components, but we’ll save that for another day (asset managers are people too).
But shouldn’t high net worth and family offices fill in that gap? Unfortunately these groups still obey the same economics as the funds. Generally speaking, they do not have the internal resources to fully research and understand specialty fields. There is a reason they are not particularly active in life sciences. Healthcare is hard. To get around it they often invest in packs to share the burden of analysis and support. Theranos didn’t get funded in a vacuum. It took a village to mess that decision up so completely.
The bottom line is this: The funding gap exists for a structural reason, and you as an entrepreneur will not change that. Instead you will need to learn how to build on your personal networks. But that is a class for another day.
Michael Schmanske is a 24-year Wall Street veteran with experience on trading desks and asset managers. He is the co-founder of Prognosis:Innovation as well as founder of MD.Capital.
