By Swati Chaturvedi

I wanted to follow up on my last post, and its assertion that deep technology startups are attractive investments, with a concrete illustration of how this is the case.

In this article, I will explore the potential returns from investing in a real deep technology startup with unique medical device technology.

Here are the terms of the investment:

• Raising $1.35M for Series A;
• At a pre-money valuation of $2.25M;
• Issuing participating preferred equity;
• With a cumulative 4% dividend (which we will ignore in this analysis for simplicity’s sake).

The company expects to raise another $1.5M in a later Series B round to get to positive cash flow. However, it recently received some non-dilutive funding from the NSF. Therefore, the total equity financing requirement may decrease.

The company has already received an investment from a VC fund, which commissioned an “FTO” (Freedom to Operate) search, in order to determine whether the company’s IP would infringe on any existing IP. Of course, the IP question will only finally be settled when the company receives its patent application decision, but the FTO search instilled enough confidence in the VC fund that the company indeed has unique, non-infringing IP.

In addition to the VC fund’s FTO search, at Propel(x), we interviewed physicians who confirmed that there is a market for the company’s deep technology.

So the key risk, in fact, is not technology but execution: Will the company be able to manufacture and distribute the product widely and profitably? At this point, the device is ready for use. The company’s plan is to launch the product, get some initial customer feedback and then partner with or sell to a much larger medical device company that will grow sales.

The company’s expected exit is 2 or 3 years down the road, via sale to a larger medical device company at ~$18M to $35M based on comparable recent medical device exits.

Let us review the returns that may be expected from this investment:

• Series A investors invest $1.35M today @a pre-money valuation of $2.25M.
• At this point, Series A investors own 37.5% of the company (=1.35/(2.25+1.35)).
• Let us assume the Series B is raised at a pre-money valuation of $5M.
• At this point, the value of Series A has grown to $1.875M (=37.5%*$5M).
• After the Series B, the post money valuation will be $6.5M (=$5M pre-money + $1.5M raised).
• Original investors in Series A will be diluted to ~29% (=1.875/6.5).
• Let us now assume the exit happens in 2 years’ time and is worth $15M (a bit more conservative than the startup estimates).
• At this point, the “participating” feature comes into play. Series A and Series B investors first receive their capital back, and then Series A investors receive an additional 29% of the remainder: a total of $4.9M (=$1.35M+29%*(15-1.35-1.5))
• This yields an expected IRR of 90%.
• Alternatively, let us assume the exit occurs 3 years down the line at a valuation of $30M.
• This would yield ~$9.2M in cash for Series A investors – an IRR of 90%.

Of course, things typically do not go quite as well as entrepreneurs plan…

Let us assume that the Series B raise is double that which is currently planned and the exit is delayed by a couple of years as well. Under these assumptions, the Series A IRR would be between 30%-40% for the two scenarios.

Is this a good deal? We will not know for sure until an exit happens. But, for now, a good comparison point is the broad market indexes, which yield about 10% annually.

The key risks are whether the product is adopted by physicians, whether the company finds a partner to distribute the product, and whether it attracts an acquirer at the right time.

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