Choose Your Own Adventure: Venture Capital or Private Equity

I write about startups and right now, it’s a particularly challenging time for them. Not the kind that front-line healthcare workers or grocery store staff are experiencing, but a challenging time nonetheless. Because of all the pain and stress in the world, I find that startups have a hard time attracting sympathetic crowds. Just check out the title of a recent NYTimes article.

To be fair the article by Kara Swisher is far more balanced than the title presumes, but it does perfectly encapsulate public perception about helping Harvard tech drop-outs raise millions of dollars to create the next “Amazon of ________.” I can’t argue that they need or even deserve money more than the locally-owned small business or restaurant from the CARES Act. However, I’m here to remind you that many of these startups are not Airbnb and some are running out of money. Let’s discuss.

Founders seeking glory and riches in the startup journey have a tough road. They need to grow quickly, while disrupting large incumbents. In addition, they must increasingly consider a pathway to profitability given VC experiences like the failed WeWork IPO. The only problem with this high-risk, high-reward strategy is that few people are willing to invest capital at this stage. Enter venture capital (VC) or private equity (PE). I never saw a VC-backed startup growing up in Northern Michigan but have become enlightened over the years. To become venture-backed, startups sacrifice stability for velocity. VCs demand Falcon Heavy rocket-propelled growth. In return, investors exchange cash for a portion of a startup’s ownership (“equity”). The typical venture-backed startup is advised to raise enough money to cover 18-24 months of operations (“runway”) each round.

This 2 year time frame is a bit like goldilocks. Anything shorter doesn’t afford the founders enough time to develop the business before having to raise another round (usually begins 3-6 months prior to closing your next round). On the other hand, similar to dog years (7 dog = 1 human), 3 years is a lifetime in startup years and difficult to project. These VCs are incentivized for entrepreneurs to deploy their capital to grow as quickly as possible, allowing them to book “gains” as the company’s valuation increases (even if they’re paper gains).

I hope you’re in the position of not needing external capital (like Mailchimp). But if you’re looking to raise funding to expand operations (or outlast COVID-19), let’s discuss the options of VC versus PE. I’d argue there’s still plenty to go around.

Venture Capital

VC and healthcare startups were on fire prior to COVID-19. If you ask me, this should continue as funds reallocate capital towards solving our country’s most pressing issues related to healthcare, education, and climate change. According to Rock Health, digital health funding was on historic levels prior to the COVID-19 pandemic. In Q1 of 2020, VCs put $3.1 billion into the market alone, exceeding Q1 levels in 2016-2019.

During the survey of digital health investors, 67% of investors stated that “digital health startups will have a much harder time raising capital in 2020 than they did in 2019.” Not great news. But given the reality of 2019 versus now, I’m actually way more skeptical of the 33% who said it would be as easy or easier than past years… I call bullsh*t.

There is good news to be had. Jon Sakoda, former NEA partner, wrote a fantastic medium article on the 2020 state of the VC industry and how long the “dry powder” will last? After looking at data from the National Venture Capital Association (NVCA) and Pitchbook, he estimates the VC industry has $150 billion of dry powder, of which roughly half ($76 billion) is earmarked as reserves for existing portfolio companies. VC is a game of outsized returns, and these reserves allow investors to double-down on existing startups that they believe can return outsized funds. This is important because over the past few decades, a small number of startups (6%) have driven 60% of all returns over the same timeline.

In general, the U.S. VC community has raised more than $275 billion from 2014 to 2020. Now healthcare is certainly not the only industry receiving VC funding, so that $74 billion in dry powder for new investments are split across social media, consumer tech, enterprise SAAS, energy, and many other industries. And just remember, investors are going to be extra careful during due diligence and ask for lower valuations than 3 months ago. That’s life I guess.

  1. Private Equity

Another potential investment option for healthcare startups looking for capital is private equity (PE). This can come in the form of growth equity or buy-outs. Now the typical terms and target company of a PE firm are not the same as VC. Oftentimes, PE firms take majority control of your company (50%+) in mature companies in traditional industries. Sometimes they replace leadership with operational partners who have previously run large divisions or companies. This business model looks to use operational and financial insights to eliminate a certain amount of inefficiencies.

The good news for healthcare startups is that healthcare is considered a PE staple. Not to mention the fact that the PE industry has significantly more dry powder than VC ($1.45 trillion). That amount has literally doubled since 2014. If interested to see the tremendous growth in global PE, check out this graph from CNBC below.

In 2019, PE firms invested $78.9 billion in healthcare deals across the globe. For any startup focused on U.S. domestic issues, nearly 59% of the total deal amount ($78.9 billion) was deployed in North America. Overall, biopharma led the way ($24.2 billion), followed closely by healthcare IT ($17.5 billion). If you fall in one of these sub-industries and are looking for large check sizes in exchange for ownership control, private equity might be for you. There are 313 other companies that felt that way last year, although they no longer own the majority of the business they built…

Andy Mychkovsky is the creator of Healthcare Pizza. Follow him on Twitter (@AMychkovsky) and LinkedIn for future thoughts and updates.


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